After years of lying dormant, inflation returned with a vengeance in 2022. The stock market’s initial response was panic, particularly in so-called long-duration assets like unprofitable growth stocks. Novice investors might understandably conclude that stocks are not equipped to handle inflation. Or, said another way, stocks are a poor way to fight inflation.
The takeaway is understandable, but it’s DEAD WRONG. Indeed, stocks aren’t just a good vehicle to fight inflation; they’re the BEST.
That means better than bonds, gold, real estate, and commodities.
Check out the following graphic from Goldman Sachs Asset Management showing the percentage of time an asset class outperforms inflation over a given time horizon.
Note the relationship between how effective stocks are at beating inflation and the length of time you hold them.
In the short run, stocks don’t always beat inflation. Over one year it’s just over 50% of the time. But as you lengthen the hold time, their inflation-fighting power increases. Over 20 years it rises to 100% of the time.
The future might be different. The ubiquitous disclaimer that past performance is no guarantee of future results isn’t just lip service. It’s true. But do you want to bet on it?
I don’t.
I’ll explain why stocks have done so well at hedging inflation shortly. But first, I want to mention another important takeaway to this year’s dismal performance versus inflation.
Beware the Short Run
The stock market reveals very little about its true nature over the short run. It’s an insane asylum that behaves extremely irrationally based on whether fear or optimism is ruling the day. A few stats help illustrate this.
First, since 1926, the US stock market has generated an average annual return of 10%.
Second, and most ironically, the market virtually never lands near +10% for its return on any given year. In fact, annual returns have landed between +8% and +12% in just seven of the past 96 years.
Third, yearly returns have ranged as high as up 54%, and as low as down 43%. I assure you, there’s rarely anything going on in the real world that impacts the lasting value of public companies to this degree. In every case like this, it’s a stock market overreaction.
Fourth, the stock market’s history is one where we move from one overreaction to another until it reflects the economic reality of the corporations that it tracks.
This should go without saying, but the only way you get to participate in the long-term growth of equity values is to withstand their short-term drama. As Peter Lynch once said,
“The key to making money in stocks is not to get scared out of them.”
Why Stocks Hedge Inflation
Here’s the math behind understanding why stocks beat inflation. The long-term average inflation rate for the United States is approximately 3%. Some decades have been far higher, and some have been far lower. To “beat” inflation, an asset must have grown by more than 3% on average. Of course, if you had inflation at 7% for a decade, then for stocks to beat it, they needed to also generate 7%+ gains for that decade.
The fact that stocks haven’t seen a 20-year period where they haven’t beat inflation means that even if inflation outpaces stocks in the short run, they eventually have enough growth to catch up.
So why do they do this?
Because profits are what drive stock values in the long run, and inflation is one of the root drivers of rising prices.
Because of its pricing power, McDonald’s can increase the cost of its hamburgers over time. Doing so increases its revenue and, ultimately, earnings. If in 2018, it charged $3 but now charges $6 for a Big Mac, then its revenue will double in nominal terms. Inflation will undoubtedly have increased the cost to make the Big Mac over the past four years, but it’s unlikely the cost bump will completely offset the revenue growth.
And even if it does in the short run, history has proven it never does in the long run. Eventually, corporate profits rise beyond the pace of inflation, allowing equity values to do likewise.
Want more? Read my Trading Justice Newsletter from June 2021 titled “How to Fight Inflation.”
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