Investors beware. The current period of prolonged low inflation that has helped fuel stock prices may not be an adequate justification for high stock valuations seen in benchmarks such as the S&P 500 (SPX) and the Dow Jones Industrial Average (DJIA​), according to the Wall Street Journal.

Until now, that benign inflation environment helped to set the stage for one of the biggest bull market advances in decades, especially benefiting sectors and big stocks as diverse as JPMorgan Chase & Co. (JPM), Inc. (AMZN), Apple Inc. (AAPL), Pfizer Inc. (PFE) and Verizon Communications Inc. (VZ).

Warning Signs

But while studies show that stocks can outperform amid low interest rates, history is rife with exceptions. The stock market slid into the 2008 financial crisis amid a period of low inflation, and tame inflation in the 1960s was followed by nearly three decades of poor stock performance. What matters most to stock prices, the Journal observes, is not the current rate of inflation, but expectations of future inflation. More specifically, the key is how the inflationary expectations reflected in stock prices today compare to the actual inflation rates experienced in the future.

The year 1979 was a great time to buy stocks because inflation was high and expected to persist, but actually was on the cusp of plummeting, helping to send share prices upwards, the Journal says. By contrast, the Journal continues, late in 1936 was a bad time to buy equities since inflation was low and widely assumed to stay so, but it subsequently shot upwards.

The Federal Reserve, which meets this week, is grappling with how quickly to raise interest rates in the face of a slow economy and inflation that has failed to reach its target of 2% annually.

The Simple View

The simple view of inflation, as summarized by the Journal, is this: low inflation leads to low interest rates; low interest rates mean that the present value of future profits and dividends are higher in present-day money; a higher present value of future profits and dividends means higher stock prices today. Additionally, corporate profits are bolstered by lower borrowing costs, and stocks become a more attractive investment relative to low-yielding bonds and bank accounts.

At first glance, history seems to confirm this simple view, the Journal says. Studies show that, on average, when an inflation rate below 4% was recorded in a given year, the S&P 500 Index rose about 8% in the next year. On the other hand, when the inflation rate was 4% or more, the market averaged only a 2% gain in the following year.

Deceptive Data

But Nobel Laureate economist Robert Shiller of Yale University is among the experts who argue that this historical relationship is highly deceptive, the Journal reports. Shiller warns that "average" data showing superior stock market performance during periods of low inflation hides huge variations. Looking at data stretching all the way back to 1871, he found that when inflation was between 1% and 2%, as it is now, the total return (price appreciation plus dividends) on the S&P 500 Index averaged a robust 8.6% for the following year. However, this average is derived from a vast range of observations extending from a gain of 41% to a loss of 35%. Whether inflation subsequently decreased or increased was the key determinant of whether gains or losses were recorded, the Journal adds.

Recent History

The tame inflation of the 1960s was one era that lulled investors into complacency. In 1965, inflation had been under 2% for seven years, and the bulls also were stampeding. Valuations were the highest since right before the Stock Market Crash of 1929, as measured by the Shiller P/E Ratio, which smooths results by comparing price to the ten previous years of earnings. As with today, the Federal Reserve had been pursuing a loose money policy. In 1967, core inflation, which excludes volatile energy and food prices, surged by two percentage points, the Journal notes. The S&P 500 would end up on a generally downward trajectory from November 1968 through June 1982, marked by the 1970s era of protracted stagflation, or economic stagflation accompanied by high inflation. It would take until December 1994 before the S&P 500 finally would forge past its November 1968 level and not turn back, per Macrotrends LLC.



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