• Nicholas Pihl

Inflation and Stock Performance

The relationship between inflation and stock market performance is not as straightforward as some pundits (and some advisors) have claimed. Specifically, many people have claimed that you need to own stocks as a hedge against inflation. This is only true over very long time horizons, though, and over the short-and-medium term, the data tells a very different, more nuanced story.

What should investors do in the face of an inflationary environment? I think Aswath Damodaran at NYU offers a useful series of data points, and overall valuable perspective in the video below. I've typed up my notes and key takeaways on this lecture, and shared them further down in this post.

Key points:

  • Damodaran believes that the Federal Reserve (Fed) does not "decide" rates, so much as influence them. He points out that the 10-year risk-free interest rate consists of an expected inflation component, and an expected "real" GDP growth rate (after inflation). Though the composition changes over time, their combined sum has very closely approximated interest rates over many decades.

  • The impact of rising rates has more negatively affected high-growth technology companies than the market as a whole. Though this video is from a year ago, this divergence has only widened over the last year. The point is more relevant, not less. The pain for tech has only increased since March 2021 when he filmed this video.

  • Historically speaking, some industries perform better in a rising inflation, or surprise inflation environment.

  • This is reflected at a quantitative level by outperformance for value stocks vs growth stocks. And in terms of valuation, this is exactly what you would expect. He breaks down valuation into two pieces, interest rates and cash flows. All companies might reasonably see an increase in cash flows due to the higher economic growth that contributes to higher interest rates. This disproportionately benefits slower-growing companies, whose earnings growth sees a larger percentage change relative to faster-growing companies. Meanwhile, higher interest rates disproportionately hurt companies with higher valuations, because higher interest rates reduce the present value of future cash flows. So the companies that had high valuations and high growth expectations fail to see much benefit from higher growth, while taking a larger hit to their valuations from the higher interest rates that higher growth elsewhere in the economy creates.

  • The same dynamic maps onto young companies vs older, mature companies. Mature companies have more cash flows, but smaller opportunities for reinvestment and future growth. Their cash flows are weighted towards the short term, rather than the long term. And in fact, that's what we're seeing in markets right now. Young, growth companies are getting whacked, and more mature companies are holding up better (and even benefitting).

  • Here's a nice summary slide of how inflation and real growth impact business fundamentals.

  • Overall, the net impact to stock returns from a higher growth, higher inflation environment is unclear. Growth and inflation are correlated with each other (but not perfectly). Stocks benefit from high GDP growth, but suffer when inflation is rising.

  • Valuing the S&P 500 as a whole, you see a range of potential values, depending on GDP and interest rates. Even his benign scenario (high growth, low rates), comes in below the current value of the index. This isn't a good sign, because it implies relatively little cushion for negative economic surprises, and minimal upside even if things go well. Markets are pricing in rosy expectations.

Woof. That's not what an investor really wants to hear, and it's not the setup I look for when investing. Looking forward, I think it's likely that stocks and longer maturity bonds could struggle for a couple of years, particularly growthier companies.

Of course, I know that I tend to be somewhat contrarian in temperament. Whatever the narrative, I tend to take the opposite bet. If it's all doom and gloom, I tend to get more optimistic and aggressive. I certainly was during the Covid crash in 2020. Conversely, markets today seem to under-appreciate the impact that an increase in interest rates could have on stock valuations.

But ultimately, financial planning is a far more valuable tool than market timing. Marking the tops and bottoms of markets is hard (impossible) to do consistently. But it's much more feasible to look over the next few years of a client's life and make sure that they have enough low-risk assets to cover their needs, while also making sure that their longer term needs for growth are provided for. It makes no sense to sell everything and go to cash when an investor still has 20 years left to retirement. That's an unnecessary risk. But it also makes no sense to take unnecessary, uncompensated risk with cash that a client will need over the next 5 years.

The right thing to do depends entirely on your circumstances, tolerance for risk, and need for growth. Creating a high quality portfolio for you isn't a one-size-fits-all market call, but rather a nuanced conversation full of thoughtful insight that guides you to what you want in life. It's at most 20% about the market's opportunity set, and at least 80% about you and your needs.

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First off, let me say, this isn't advice tailored to your individual situation. HSAs aren't a good fit for everybody, as I discuss at the end of this article. But if it's a good fit, HSAs can be prett