How well will stocks do in times of high inflation?

April 28th, 2009

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As we all know, governments all over the world are engaging in expensive and wasteful bailouts, stimulus and printing of money. Naturally, this resulted in many investors being worried about the long-run impact on price inflation. Already, contrarians like Marc Faber, Warren Buffett and Jimmy Rogers are making the high inflation call.

Investors are scrambling for ways to hedge against high inflation. One of the asset class being considered to do that job is stocks. Indeed, Zimbabwe is a great example of the world’s ‘best performing’ stock market in the midst of hyperinflation (see Zimbabwe: Best Performing Stock Market in 2007?). In a hyper-inflationary economy, earnings can soar in nominal terms through the sheer force of price inflation. Therefore, stock prices will definitely rise in nominal terms.

So, should you rush out to buy any stocks if you are worried about hyperinflation in the future? Before you do so, take note of these points:

  1. A hyper-inflationary economy is in deep trouble. Unemployment can be very high (e.g. the stagflation of the 1970s, 90% unemployment rate in Zimbabwe), many businesses will fail and there will be social problems. You will likely witness depleted store shelves as there will be shortages of goods. Therefore, in such economic environment, not all businesses will survive. This means that many stock prices are going to be zero. You will not want to buy into one of them.
  2. Our theory is that in hyper-inflationary times, while stock prices can go up tremendously in nominal terms, their price-earning (PE) ratios will decline. The reason is not so much due to earnings growth expectation. Instead, it will be due to higher discount rate applied by the market. Remember back in Quantitaive demonstration of the effects of price inflation on your investment, we showed you how high inflation can easily make a mockery of your investment returns if you apply a discount rate that turns out to be far below the inflation rate. Historically, the rate of inflation for hyper-inflations increases exponentially. This may translate to higher and higher inflation expectations, which result in higher and higher discount rates, which in turn imply lower and lower PE ratios.

Zimbabwe’s experience shows that in nominal terms, stocks are great investments. But in real terms, their performances are very restrained.

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