Tales of a Technician: Inflation: The Hidden Driver of Stock Prices
July 8, 2015
Last Update: August 2021
Today’s musings focus on a topic that’s been roaming the halls of the idea factory in my head for the past few days:
For many, it’s a depressing topic. Who wants to be reminded that if their money isn’t growing, it’s shrinking?
While today’s piece is far from a comprehensive look at the insidious purchasing power killer, it will touch on an incredibly important, yet rarely understood the concept about inflation and stocks. Namely, inflation causes the stock market to rise over the long haul.
Let’s begin by pulling back the curtain to reveal how the stock market can double without becoming any more expensive.
First off, the terms cheap and expensive don’t just refer to a stock’s price tag. A $100 stock can be cheaper than a $20 one, for example. Most of the time, those trying to determine the relative price of a stock are using a fundamental metric called the P/E or price to earnings ratio.
Rather than looking at a stock’s price in a vacuum to determine if it is cheap or expensive, we look at it relative to the company’s earnings.
If XYZ were trading for $100 and made $10 in earnings per share annually, we would say its P/E ratio is 10. Or, in other words, XYZ is trading for 10x earnings.
If ABC were trading for $20 and made $1 in earnings per share annually, we would say its P/E ratio is 20. Or, in other words, ABC is trading for 20x earnings.
So here we have a $20 stock that looks twice as expensive as a $100 stock from a valuation perspective (let’s leave growth potential out for simplicity’s sake).
Now, suppose due to inflation the price of every good sold by XYZ company doubled. Instead of selling widgets for $5 apiece, they now go for $10 apiece. Over the next year, their earnings rise from $10 to $20 – not because the company grew, mind you; simply because the nominal price of widgets doubled due to inflation.
At the same time, the stock price doubled from $100 to $200. What began as a $100 stock making $10 in earnings is now a $200 stock making $20 in earnings.
Now for the million-dollar question.
Is the stock price more expensive?
The layman may say yes because $200 is more than $100. And yet, from a valuation perspective, XYZ is still trading at 10x earnings. Nothing has changed. It’s just as expensive at $200 as it was at $100.
What if over the next 50 years, thanks to inflation, the cost of these once $5 widgets continued rising until they were $100 apiece. Assuming XYZ company continued to sell the same number of widgets every year, could their stock price ascend all the way to $1000 without really becoming any more expensive?
The answer is yes. At a seemingly lofty $1000, its stock price isn’t any more expensive than it was at $100.
This little case study reveals why inflation is one of the biggest drivers of long-term stock returns. It lifts earnings over time, which allows prices to rise commensurately without sending valuations to unsustainable levels.
…and now you know why the advice to put money in the stock market to hedge against inflation is so commonplace.
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5 Replies to “Tales of a Technician: Inflation: The Hidden Driver of Stock Prices”
Thanks Tyler, very nice and concise explanation!
That makes so much sense now!
I’ve heard this before but never understood it so clearly! Thanks alot Tyler
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