How Inflation Impacts the Stock Market…

Inflation. That dirty, little word is starting to be bantered around for the first time in a long time. The Federal Reserve has done a masterful job constraining inflation over the past decade. This is one of the key reasons for the stock market’s unprecedented rise. However, the rising cost of energy might trigger a new resurgence in inflation.

We believe that the rise in energy prices is real and not just a blip that will go away any time soon. Over the past twelve months, the price of oil has increased more than 50% to over $36 a barrel (it’s highest price since the Gulf War!) and natural gas has gone up a whopping 106%. The main reason for this rise has been a higher demand for energy worldwide. In the past five years, China and Indonesia have gone from net exporters to net importers of oil. Put simply, there is more demand for oil, and energy as a whole, than is currently available.

Since most of today’s investors don’t remember an inflation rate of more than 2-3%, we thought it would be wise to look at what happens to stocks during periods of rising inflation. Below is a chart that shows how the stock market (as represented by large company stocks) performed under different inflation rates. As you can see, the market performs poorly when inflation rises above 4%. It is important to note that this chart only looks at large company stocks and does not show how other segments of the market perform.

History has shown that when inflation rises, growth stocks that are selling for a premium to the market (a higher P/E ratio) tend to be the worst performing sector. For example, during the 70’s oil crisis, inflation from the end of 1972 through the end of 1981 averaged over 9% annually. Large company, high P/E growth stocks (such as Disney) produced negative returns over this 9-year period. However, other parts of the market performed much differently and actually produced positive returns. Over the same 9 years, small company stocks generated an annual 16% return and international stocks were up close to 8% annually. Even large company value stocks held up well during this rough period outperforming large company growth stocks by over 6% annually. So far this year, our clients’ portfolios are producing positive returns while the overall stock market is negative. This is mainly due to our over weighting in small company stocks.

UPDATE:

Mark & Jim have been rescheduled to appear on “On the Money” with Chris DeSimio. This will take place on Saturday, October 7th, on WVXU (91.7 on your FM radio dial) at 10:00 a.m. Please join us!