Do Common Stocks Still Offer Protection Against Inflation?

There seems to be no doubt that, in general, a managed, diversified portfolio of US common stocks has provided investors with ample protection against inflation over the last half century.

There is, however, a question as to whether a similar level of inflation-protection through common stocks will continue to be available over the next fifty years.

Intrinsic Kernels of Inflation Protection

To the extent that a class of securities has a legal claim to assets that will increase in value with inflation, that class of securities may be said to have inherent protection against inflation.

Certain assets offer no protection against inflation whatsoever. These assets include investments in cash, fixed-principal-and-interest bonds, and accounting intangibles such as good will.

Other assets, such as real estate and commodities, tend to increase in value with the consumer price index.

It is useful to think of different investments as offering varying degrees of protection against, depending upon how large a “kernel” of inflation-resistant assets they have relative to the assets that make up the investment.

Intrinsic Inflation Protection Varies
Intrinsic Inflation Protection Varies

For a simple example, let us define inflation as the price of gold. Let us imagine two boxes of equal size, one entirely filled with gold, the other empty, except for a small cube of gold.

If both of these boxes sell for the same price, it is clear that the box entirely filled with gold has a greater “kernel” of inflation-protection that the box with only a small cube of gold.

The Kernel of Inflation-Protection in Common Stocks

Many common stocks offer protection against inflation because both the value of sales and the cost of goods sold tend to increase along with the consumer price index, as shown in this table

Account Year 1 Year 2 increase
Sales 100 120 20%
Costs 80 96 20%
Profits 20 24 20%
Dividends 10 12 20%

The table shows the income statement of a company that sells a constant volume of consumer goods in an economy with inflation of 20% a year.

The value of sales increases 20% along with consumer prices, as does the cost of goods sold. Profits also increase 20%, the same rate as inflation. If dividend payout remains constant at 50%, dividends also increase 20%.

In traditional markets, dividend yields are related to bond yields, which, in turn, tend to increase and decrease with inflation.

In inflation is constant, the value of the stocks of this company should increase along with inflation — provided that the stock was not already over-priced.

Common Stocks Do Not Always Protect Against Inflation

The degree of protection against inflation offered by common stocks depends upon the price paid relative to the internal “kernel” of inflation-resistance built into the investment.

For example, an investor in common stocks in 1929, before the Great Crash, even with investments that survived the Depression of the 1930s, would have, on average, have had to wait until 1966 (37 years) to recover the initial value of his portfolio.

The high level of total returns on common stocks over the last fifty years is often cited as “proof” that stock investment offers protection against inflation. However, these apparent attractive returns are misleading for several reasons:

  • Increase in Price-Earnings Ratios: From 1945 to 2000, average price earnings ratios on the S&P 500 increased from ten to thirty.

  • Price Manipulation Through Buybacks: The increase in price-earnings ratios since the 1980s was not due to greater investment merit, but rather to raw price manipulation through corporate buybacks.

  • Low Starting Point: Price earnings ratios in 1945 (around ten) were significantly lower than the long-term average of fifteen, because the investment market was only beginning to recover from of the Depression of the 1930s.

  • A False Yardstick: The most common measure of average returns on common stocks over long periods is the S&P stock index, which is heavily biased in favor of successful investments. (See: “Are GAO Projected Returns on Equities Reasonable?“)

  • Declining Corporate Income Taxes: Corporate income taxes have been falling since the end of World War II. The average corporate tax rate over the period 1952 to 1989 was 40.6%, compared to an average rate of 29.6% in the 1990s.

In other words, to answer the question, “Do Common Stocks Still Offer Protection Against Inflation?”, we have to look to the future rather than the past and apply commonsense in evaluating current levels of stock prices relative to the inherent “kernel” of inflation-protection (increasing dividends).

Over-Priced Equities Reduce or Eliminate Inflation Protection

Obviously, if there is a chance that common stocks are significantly over-priced, and that a reduction of 40-50% in value is indeed possible, then the prudent investor should consider crossing common stocks off the list of inflation-resistant assets.

Because common stocks are now sold at much higher prices relative to dividends and earnings than in the past (See: Investment Value), and because even academic observers are now beginning to suggest a 40 or 50% devaluation in stock values (See: Are GAO Projected Returns on Equities Reasonable?), a prudent investor should not blindly accept the premise that common stocks offer inherent protection against inflation, at least at today’s prices.

There are, of course, exceptions, such as equity REITs that hold diversified portfolios of income producing properties, against non-indexed debt, and that sell at prices that produce yields consistent with current interest rates.

However, the average common stock investor, investing in common stocks through equity mutual funds and 401(k) plans, may be in for tough times.

 
Bookmark and share this article:These icons link to social bookmarking sites where readers can share and discover new web pages.
  • blinkbits
  • BlinkList
  • blogmarks
  • co.mments
  • connotea
  • del.icio.us
  • De.lirio.us
  • digg
  • Fark
  • feedmelinks
  • Furl
  • LinkaGoGo
  • Ma.gnolia
  • NewsVine
  • Netvouz
  • RawSugar
  • Reddit
  • scuttle
  • Shadows
  • Simpy
  • Smarking
  • Spurl
  • TailRank
  • Wists
  • YahooMyWeb
divider
divider

Please add your comment

Please review carefully before submitting. All comments are moderated and edited.

copyright | privacy | home

Powered by WordPress | Entries (RSS) | Comments (RSS)