If inflation is a threat to the stock market, we should be scared. That’s because inflation expectations have soared dramatically in recent weeks. The 10-year equilibrium rate of inflation, which the bond market is currently betting that inflation will average over the next decade, is now higher than it has been in five years. As you can see in the attached graph, the 10-year expected inflation was only 0.50% last March; last week it reached 2.24%.
In reality, inflation is not the threat to the stock market that most investors believe. If inflation continues to rise in the coming months and investors react by ditching the stocks, you may want to look at it as a buying opportunity. These are the conclusions I came to after interviewing Richard Warr, a finance professor at North Carolina State University. Warr co-authored a seminal 2002 study in the Journal of Financial and Quantitative Analysis that found that stocks are actually a good long-term hedge against inflation. His co-author was University of Florida finance professor Jay Ritter. Warr explained that stocks are a hedge because inflation affects stock valuations in two ways that largely offset each other: Higher inflation means that future nominal earnings must be discounted at a higher rate when calculating their value. Present. Corporations can charge more when inflation is higher. Because of this increased pricing power, your nominal earnings in future years will be higher than they would have been otherwise. Notice the small net effect of these two factors: nominal earnings will be higher, but they should be more discounted. By the way, this is not just a theory: for the past 150 years, real growth rates (adjusted for inflation) for the S&P 500 SPX, earnings per share of -0.19% have been relatively stable in the wake of changes in the inflation rate, while nominal EPS growth rates have tended to rise and fall in line with those changes. Investors often focus on the first of these two consequences of inflation, Warr said. That is, they realize (at least implicitly) that inflation reduces the value of future nominal gains, but they overlook that those nominal gains will themselves be higher. This biased view is due to a trait that economists call the “inflationary illusion.” This illusion works to benefit stocks when inflation is decreasing. When that’s the case, investors extrapolate artificially high nominal earnings growth from earlier periods of higher inflation into the future. The result is excessively high valuations. When inflation begins to rise, by contrast, investors make the opposite mistake: they extrapolate into the future the lower earnings growth that companies produced during the previously low inflation period. This leads them to conclude that stock valuations must decline as inflation rises. Rational Versus Behavioral Models of Investor Behavior Note that two different models of investor behavior are needed to explain the market’s reaction to higher inflation. The rational model shows that inflation should have little net impact on equity valuations, while the behavioral model predicts that investors will nonetheless behave irrationally. Could investors have learned from its past irrationality and thus not ditch the stocks if inflation rises further in the coming months? Warr said that while anything is possible, he wouldn’t bet on it. “Most of today’s investors have lived most of their lives in a low inflation environment, so they have not had the opportunity to learn the lessons that history teaches us about inflation and the stock market.” If Warr is right, rational investors in the coming months will have a chance to recapture lower-valued stocks. Mark Hulbert is a regular contributor to MarketWatch. Your Hulbert Ratings tracks investment bulletins that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org Also: The S&P 500’s 12-month follow-up performance is about to skyrocket. Also read: What does the peak of a bull market in stocks signal? Don’t raise interest rates