Inflation affects equity prices in several ways. Most importantly, investors are willing to pay less for a certain level of earnings when inflation is high and more for a certain level of earnings when inflation is low (and expected to remain so).

Key Takeaways

  • Inflation is when the purchasing power of a currency declines over time, which has the effect of rising price levels.
  • Companies tend to pass rising costs of production on to their customers, making stocks a pretty good hedge against inflation, in general.
  • Investor expectations also are modified by inflation estimates, with higher inflation leading to higher expected returns.
  • When inflation is high, P/E ratios tend to go down since earnings, in the denominator, will tend to rise more quickly than the stock price.

Review of the P/E Ratio

Let's review the two concepts involved: the price-to-earnings (P/E) ratio and inflation. The P/E ratio is a valuation measure showing how much investors are willing to pay for a company's earnings. For example, if the price of a stock is $50 and earnings per share is $2, then the P/E ratio is 25 ($50/$2). This shows that investors are willing to pay 25 times the company's earnings for a share. Inflation is a measure of the rate of price increases in the economy.

Exploring the Relationship

Stable and moderate inflation means a higher probability of continued economic expansion. Modest inflation usually means that the central bank won't be raising interest rates to slow economic growth. When inflation and interest rates are low, there is a greater opportunity for higher real earnings growth, increasing the amount people will pay for a company's earnings. The more people are willing to pay, the higher the P/E.

When inflation levels are stable and moderate, investors have lower expectations of high market returns. Conversely, expectations rise when inflation is high. When inflation rises, so do prices in the economy, leading investors to require a higher rate of return to maintain their purchasing power.

If investors demand a higher rate of return, the P/E ratio has to fall. Historically, the lower the P/E, the higher the return. When you pay a lower P/E, you're paying less for more earnings and, as earnings grow, the return you achieve is higher. In periods of low inflation, the return demanded by investors is lower and the P/E higher. The higher the P/E, the higher the price for earnings, which lowers your expectations of healthy returns.

During times of low inflation, the quality of earnings is considered to be high. This refers to the amount of earnings that can be attributed to actual growth in the company and not to outside factors like inflation.

For example, say inflation is 10% per year (which is high), and a company purchases a widget for $100. In one year, the company will be able to sell that same widget for at least $110 because of inflation. Because its cost for the widget remains $100, it appears to have increased its profit margin, when really the growth is all inflation's doing. In general, investors are more willing to pay a premium, or a higher multiple, for actual growth compared to artificial growth caused by inflation.

Inflation and Stock Returns

Examining historical returns data during periods of high and low inflation can provide some clarity for investors. Numerous studies have looked at the impact of inflation on stock returns.

Unfortunately, these studies have produced conflicting results when several factors are taken into account, namely geography and time period. Most studies conclude that expected inflation can either positively or negatively impact stocks, depending on the investor's ability to hedge and the government’s monetary policy.

Unexpected inflation showed more conclusive findings, most notably being a strong positive correlation to stock returns during economic contractions, demonstrating that the timing of the economic cycle is particularly important for investors gauging the impact on stock returns. This correlation is also thought to stem from the fact that unexpected inflation contains new information about future prices. Similarly, greater volatility of stock movements was correlated with higher inflation rates.

The data has proven this in emerging countries, where the volatility of stocks is greater than in developed markets. Since the 1930s, the research suggests that almost every country suffered its worst real returns during high inflation periods. Real returns are actual returns minus inflation. When examining S&P 500 returns by decade and adjusting for inflation, the results show the highest real returns occur when inflation is 2% to 3%.

Inflation greater than or less than this range tends to signal a U.S. macroeconomic environment with larger issues that have varying impacts on stocks. Perhaps more important than the actual returns are the volatility of returns inflation causes and knowing how to invest in that environment.

The Bottom Line

History has shown that investors realize this phenomenon and take inflation into account when valuing stocks. When inflation is high, P/E ratios are low; when inflation is low, P/E ratios are high.