A lot of newbie investors don't realize how good of an inflation hedge stocks are. In the super long run, they have beat bonds, real estate, and even gold. As long as one doesn't buy at a major peak (such as 1929 or 2000) their stock investment should more than handily beat all other asset classes. Mark Hulbert wrote an article for the New York Times commenting on the misnomer regarding inflation and stocks. In it, he refers to studies that show that corporate profits have generally grown faster than inflation:
Over the last eight decades, corporate profits have tended to grow faster when inflation is higher. In such periods, companies have been able to pass along higher costs to their customers. As a result, even though higher inflation leads to a greater discounting of future years’ earnings, those earnings tend to be bigger than they would have been otherwise. The net result is that the current value of a company’s future earnings remains relatively stable in the face of rising inflation.
Not all companies are created equal but most manage to keep their inflation-adjusted earnings growing even in inflationary periods. You would be hard-pressed to find too many other assets that can do as well as stocks can during inflationary periods. Even the much vaunted commodities will correct hard--50% drop is not unusual--and leave you questioning your returns. The only thing that can beat stocks is gold but, contrary to what goldbugs say, it requires precise timing (look at the almost 20% drop in gold or 40% drop in silver within the last two months--such a move would be a major crash for broad market stocks but is nothing unusual for precious metals.)
The risk for investors, though, is that the market will start discounting stocks using lower inflation-adjusted returns during inflationary periods. Even if stocks will outperform most other assets during inflationary periods, stocks with rosy built-in projections will get re-priced.
Contracting Profit Margins A Greater Threat
The biggest threat to stocks right now is not inflation but the unsustainably high corporate profit margins. Many stock-market investors don't realize that most of the profits over the last 5 years has been accumulating to businesses and this will likely reverse. Warren Buffett also alluded to this a few years ago when he referenced a chart showing corporate profits as a percent of GDP (refer to this post from Rational Angle for some past views from Buffett.) It is a certainty in my eyes that corporate profits as a percent of GDP will decline in the future. So be prepared for it! On top of bogus profits--such as "profits" from subprime loans to people who clearly were never going to pay them back--dissapearing, the most likely way corporate profits will decline is with higher taxes.
A future Democratic Presidential administration under Barack Obama will likely reverse the so-called tax-cuts for the wealthy (some of these cuts never should have been enacted in the first place.) A John McCain administration likely won't immediately reverse the massive Bush tax cuts but will still increase taxes in my view. The US government deficit is getting totally out of control and hence I think taxes will be raised regardless of who is drawing up policy (cutting some inefficient branches of the government or war spending is the ideal route but that ain't happening.)
Anyway, the market will likely discount stocks (downward) when profit margins contract. If you are a contrarian or a value investor buying with a big margin of safety, this won't have a big impact; but if you are buying close to market valuations, it will likely be a bigger issue than inflation.
(NOTE: Everything I say here applies to developed stock markets and USA/Canada in particular. Developing markets are totally different, with inflation being a huge problem almost at all times. Far more businesses in developing countries will have problems earning above inflation than in developed countries. It is much harder to pass down prices due to price controls, price ceilings, etc.) Tags: commentary