Hussman Weekly Market Comment: Inflation Myth and Reality
As for the stock market, it is desirable to believe that stocks will prove to be a good hedge against inflation, since they are after all a claim on nominal cash flows which grow over time as prices increase. This was certainly the expectation in the early 1970's, when inflation risks were dismissed by investors in the belief that earnings would keep up with general prices.
Unfortunately, the view that inflation pressures are benign runs opposite to historical evidence. Specifically, there is a relatively high correlation between inflation rates and earnings yields. Investors tend to systematically elevate P/E ratios when inflation rates are low and depress P/E ratios when inflation rates are high. Which is not at all to say that this behavior is rational. To the contrary, the high P/E multiples that coincide with low inflation are also associated with unusually poor subsequent nominal and real returns. Conversely, the low multiples that coincide with high inflation tend to be associated with unusually high subsequent nominal and real returns.
The implication is that (barring actual deflation) investors view low inflation as a "feel-good" indicator and drive stock valuations excessively high in response. Conversely, they tend to punish stock valuations so much when inflation is high and variable that stocks actually tend to deliver very good subsequent returns. Transitions between low inflation to high inflation, then, tend to be quite painful for equity investors, while transitions from high inflation to low inflation tend to be unusually pleasant.
Fortunately, we have enough data both domestically and internationally to analyze inflation-prone environments with the expectation of dealing with them effectively from an investment standpoint. To understand the investment environment is to know how to respond. Presently, the greatest uncertainty for us continues to be the dichotomy between typical post-recession market dynamics and the much more difficult environment that we may very well actually be in, if previous credit crises in history are any guide. We share none of Wall Street's confidence that the more difficult possibility should be dismissed, and suspect that it is premature to declare the credit crisis over.
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