Inflation and Stocks

Fundamentals of Market Investing by Adam J. McKee

When inflation rises, there tends to be a decrease in equity prices.  The idea behind this phenomenon is simple.  Future earnings as measured in nominal dollars will not be worth as much in real dollars because of the rising interest rate.  This may not seem very logical until you contemplate that the present value of stocks is considered by many to be the discounted future value of future earnings.  In an inflationary environment, those future values, while nominally higher, will not be as high in real dollars (i.e., inflation-adjusted dollars).

More precisely, when the inflation rate is steady, share prices rise in proportion to the price level to preserve a persistent ratio of share prices to real earnings.  In contrast, an upsurge in the expected future rate of inflation causes a concurrent fall in the ratio of share prices to present earnings.  Though share prices then rise from this lower level at the higher rate of inflation, the ratio the price of shares to real earnings is perpetually lower.  This permanent reduction in the price-earnings ratio occurs because, under prevailing tax rules, inflation raises the effective tax rate on corporate sources of income.  For investors, this means that we want to see what the FOMC wants to see; we all want inflation to be small and, perhaps more importantly, steady.

I have constantly warned about misinformation in the investing world.  The above facts are in sharp contrast to the popular investing myth that share prices are depressed because inflation increases the rate of interest that can be earned by investing in bonds.  It is apparent that this logic should be rejected since the higher nominal rate of interest generally corresponds to an unchanged real rate of interest.  Indeed, since the entire nominal interest is subject to the personal income tax, the real rate of interest net of the individual income tax actually falls.  (Net of tax is most commonly calculated by taking gross figures, like the income from work and investments, and subtracting the taxes paid).

With existing tax rules, inflation is likely to depress the real net rate of interest by less than it lowers the real net return to equity investment.  The simple valuation model that computes the share value by discounting at the real net rate of interest leads to the deduction that, with current tax laws, an increase in inflation decreases the amount that traders are willing to pay for shares.

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