Are stocks a good hedge against inflation?

No.

A hedge is an asset that protects against a particular kind of undesirable environment. A thoughtfully-constructed portfolio will include many different kinds of hedges so that it will generate a positive real return with low variance. This is true diversification. For example, you can profit during periods when the economy grows more slowly than expected by owning government bonds.

What about a period when inflation is faster than the markets expect?

Some people are misleading the investing public into buying shares to protect against that outcome. The theoretical argument is seductive: company profits will rise along with the price level and provide a real return above inflation. To bolster their case, the stock salesmen often point to charts that look like this (all data courtesy of Professor Shiller, calculations are mine):

This chart shows that an investor with a time horizon far longer than that of any normal human will beat inflation just by owning stocks and reinvesting the dividends. It does not answer the question of whether equities are a good place to park your money when the price level is rising rapidly.

The test is whether a stock portfolio’s value rises at least as quickly as the CPI when inflation is accelerating. An asset that hedges against an inflation surprise will do well (in real terms) when the price level grows faster than the market expects. If the rate of inflation is stable and predictable, the markets will price bonds, stocks, and commodities so that they will do equally well relative to the risk you take.

The following chart looks at the returns from owning stocks (and reinvesting dividends) under two different scenarios. The blue line shows the value of a $100 portfolio (after accounting for inflation) that only buys shares when the monthly rate of inflation is faster than its 3-year trailing average while the red line shows the real value of a portfolio that only buys shares in months when inflation is decelerating:

Even accounting for the deflation of the Great Depression, stocks did more than 6000 times better during periods of decelerating inflation since 1871. Moreover, an investor who only bought shares when inflation was accelerating would have lost more than 90% in real terms.

Perhaps it is not fair to include the pre-WWII period. After all, that was before we abandoned the gold standard and discovered countercyclical macro policy. This is the record of the same test starting in 1950:

During the past six decades, stocks did more than 33 times better when inflation was decelerating than when it was accelerating. An investor who only bought shares during periods of accelerating inflation would have lost 23% in real terms.

It looks like stocks are a poor hedge against inflation, even if all dividends are reinvested. This is significant because most people do not reinvest all their dividends. Retirees need the income to support their consumption, especially when times are tough.

What happens when inflation is high and rising for a sustained period and investors want to be able to rely on their dividends to support themselves? Does the underlying principal (the price of shares) maintain constant value in real terms? Do dividends grow at the same pace as the CPI?

There is an easy way to answer these questions, since the U.S. endured a sustained period of accelerating inflation from the late 1960s through the early 1980s. The historical evidence suggests that it would have been smarter to have avoided shares:

Dividend growth failed to keep up with the consumer price index. The S&P fell by more than half in real terms. On the other hand, money parked in a savings account (represented by owning a 3-month t-bill) would actually have grown over the period in real terms. Had investors bought gold or been able to purchase inflation-linked bonds (which had not yet been invented), they would have done better still.

One final point needs mentioning. While stocks do much better when inflation is slowing, they do worst (in real terms) when the price level is declining:

Bottom line: stocks are not a good hedge against wild changes in the price level.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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