Does Inflation Drive The Stockmarket?
Posted by: Brian Dennehy
A few questions came up in recent weeks on the outlook for inflation and how this would impact your investments, and your investment choices. My suggestion was that inflation is not a factor which you need to take into account, and I thought you would find it helpful to have a bit more detail on that point.
Over the years there have been many studies looking at the impact of inflation on stock returns. Unfortunately they do not produce clear results, in fact the results conflict. Some studies suggest expected inflation can help investment returns, others suggest the opposite.
Most of these same studies include a literature review which gives you a sense of the scores if not hundreds of papers on the point, stretching from the famous economist Irving Fisher in 1930 to one in 2017 taking into account the impact of Brexit in that same year. Taken together they are all of very limited practical value other than to highlight that you should not waste your time trying to figure the outlook for inflation if you want to know what might happen next in the stock market.
One area where the evidence does appear to be clearer is that Value stocks perform better in periods of higher inflation, whereas Growth stocks perform better during low inflation. Assuming that Value stocks and sectors are likely to be more cyclical, this makes sense because in a self-sustaining cyclical economic recovery (not what has occurred over the last 10 years) rising demand will tend to push prices up.
In contrast, low inflation over the last 10 years went hand in hand with Growth stocks, dominated by technology, outperforming by a wide margin. It is the rotation away from those Growth stocks, and rising expectations of inflation, which appear to have coincided earlier in November. Value stocks/sectors/funds are now in the driving seat.
However, I do not have to guess future inflation to figure the value in Value. I note the value, and then wait to observe a turning point.
The central banks have been trying to conjure up inflation, and economists have been forecasting inflation, even hyper-inflation, for the last decade. You would have wasted a lot of time listening to their lofty ambitions and weighty arguments.
Trying to figure correlations between inflation and the stock market is not helped by the fact that there is no universally accepted definition for inflation, an apology made at the beginning of many studies on the subject.
“We know much less about the economy than we think we do”
So said William White, former chief economist of the Bank for International Settlements, sometimes called the source of banking and economic advice for the central banks around the globe. He says there must be greater humility from economists – too many assume simple correlations.
A great example is Irving Fisher in 1929. Undoubtedly an accomplished economist – but he had nothing useful to say about the stock market, in fact he was downright dangerous. “Fisher says Prices of Stocks Are Low,” said a headline in the New York Times on October 22, 1929, referring to comments made by Fisher. We all know what happened next.
Lastly, looking back to our 19 Bad Habits, no.8 tells us:
“Our brain fools us into thinking that if we have more information we can reduce uncertainty”
I call it the Illusion Of Insight, and it drives us even more when uncertainty is at its greatest – just as now.
No.10 take a direct shot at the economists. Investors compulsively seek out forecasts on the likes of interest rates, inflation, or recessions, because they think it has some relevance to your investments.
Let me make this clear – economic forecasting, whether by economists or otherwise, is a mug’s game.
In 2001 an IMF economist published a survey of the accuracy of recession forecasts by economists throughout the 1990s. He found that their record of failure was not far off 100%.
In June 2018 an updated survey was undertaken, over a longer period taking into account the 2008/9 period. As one commentator put it:
“The record of failure remains impressive”
Do NOT buy any investment based on your prediction, or anyone else’s prediction of inflation, or some other economic factor.
The influences on the stock market are many, economic and otherwise. So the best place to look for clues is the stock market itself – because the prices in the stock market, and the trends, are the melting pot for all of those influences.