This article is an excerpt from the Shortform book guide to "The Intelligent Investor" by Benjamin Graham. Shortform has the world's best summaries and analyses of books you should be reading.
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How are inflation and the stock market connected? Do stocks perform well during inflation?
Inflation and the stock market affect each other every day. Ideally, you’ll want to invest in stocks that can resist inflation.
Read more about inflation, the stock market, and how to invest intelligently.
Inflation and the Stock Market
How do stocks and businesses perform during inflation? There’s a lot of variability and plenty of exceptions to any rule, but, in his commentary looking back over the 20th century, Zweig notes in general about inflation in the stock market:
- In periods of steady mild inflation, stock returns outperformed inflation.
- In periods of high (above 6%) inflation, stocks performed poorly. This might be because high inflation disrupts the economy—consumers purchase less, and businesses suffer.
Why Do Stocks Resist Inflation?
(Shortform note: This is a technical section we’ve included to be comprehensive; it’s not too relevant for the typical defensive investor.)
There are some ideas about inflation in the stock market. One theory of why stocks resist inflation is that during a time of inflation, a business’s costs increase, but it can also increase its prices at the same time, thus preserving its profits. In theory, a business can grow its revenues and profits at the same rate as inflation, and its stock price rises with inflation as well. In other words, a business can pass on the costs of inflation and stock prices to its customers.
Graham analyzes these claims and finds that they fall short. Looking back on the 20th century, he agrees that stock prices have risen faster than inflation, but not because inflation and stock prices had a direct effect on company financials. If the theory above were true, then companies would show higher earnings on capital during inflation (because the earnings should rise with inflation while the old capital investment stays the same). But this hasn’t appeared—earnings on capital have not kept pace with consumer prices.
Instead, much of the gain in earnings and stock price from 1950 to 1970 was due to two factors:
- Reinvestment of profits into the business
- Increasing corporate debt, used to grow the company faster
Protecting Against Inflation
Other than stocks, these two asset classes can also help protect against inflation in the stock market.
- Real estate: Prices of real estate tend to rise with inflation. However, Graham warns that real estate prices can be volatile, and you can easily make mistakes buying the wrong property for the wrong price. In his commentary, Zweig recommends Real Estate Investment Trusts (REITs), which are tradable securities that hold a diversified basket of real estate properties.
- Treasury Inflation-Protected Securities (TIPS): Introduced in 1997, TIPS are inflation-indexed bonds, meaning the value adjusts to inflation. You can buy them from the US government or from a fund as offered by Vanguard. Oddly, increases in TIPS principal value are taxed as income, so consider buying TIPS in a tax-deferred retirement account like an IRA or 401(k).
Other assets are commonly considered to protect against inflation, but Graham is skeptical when in comes to inflation and the stock market:
- Gold: Gold’s supply doesn’t change much over time, as opposed to central banks creating more paper money, so it’s theoretically less subject to inflation. However, the price of gold has historically had a poor correlation with inflation, since gold prices fluctuate based on other factors.
- Exotic assets, like art or diamonds. Graham says he’s out of his depth here, and most readers likely are too.
Now that you know about inflation, the stock market, and investing, you can make smarter choices for your investments. Remember that the relationship between inflation and stock prices isn’t always direct, and you’ll need to do research.
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