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In the past, annual inflation has gone above 7%, which is the canonical average annual rate of return for stocks.

When inflation reaches that point again, would be it still be worth investing stocks in the way people do it today? Or would it be wiser to put the bulk of that stock money into an inflation-tracking ETF?

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    What research have you done so far? It's a simple matter to pull a data set for inflation numbers and line it up next to stock returns. – JoeTaxpayer Jun 14 '16 at 20:13
  • There doesn't seem to be a ton of correlation between the stock market and inflation. During the stagflation period, it doesn't seem like the stock market outperforms the rate of inflation. – William Jun 14 '16 at 21:03
  • If the second sentence is fact, the real returns occur only during periods of low inflation. That would be ok, but it contradicts the answer below. – JoeTaxpayer Jun 14 '16 at 21:05
  • @JoeTaxpayer Even if true (which I don't know the history on either way), it doesn't say anything about "periods of inflation" in general. Stagflation was two things combined: high inflation and low growth. If the stock market matched inflation during that time, it means the real stock market growth was low. I'd be more likely to attribute that to the "low growth" part than the "high inflation" part. To see what inflation does by itself to real stock market growth, we should choose other time periods that show us the two effects separately. – Mike Haskel Jun 14 '16 at 21:26
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    What country are you asking about? Inflation has been far below that in some countries, and far above that in others. Your rate of return assumption is also market-dependent. And what do you mean by "inflation-tracking ETF"? What securities does that hold? – Chris W. Rea Jun 14 '16 at 22:52
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The relation between inflation and stock (or economic) performance is not well-understood. Decades ago, economists thought inflation corresponded with periods of high growth and good real returns, but since then we have had periods of low inflation and high growth and high inflation with low growth. It is generally understood among current economists that inflation levels (especially expected inflation) are neither indicative nor causative of real stock returns. Many things can affect inflation, and economic performance is only a minor one. Many things can cause economic performance, and inflation is only a minor one. It's not clear whether the overall relation between inflation and real stock returns is positive or negative.

Notice, however, that in principle stock returns are real. That is, the money companies make is in inflated dollars so profit and dividends for a company whose prospects have not changed should go up and down at the same rate as inflation. This would mean if inflation goes up by 5% and nothing else changes, you would expect stock prices to go up by the same proportion so you wouldn't have strong feelings about inflation one way or the other. In real life stock prices will go up by either more or less than 5% but I'm not comfortable saying which, on average.

Bottom line: current levels of inflation can't really be used to predict real stock returns, so you shouldn't let current inflation guide your decision about whether to buy stock.

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    +1 and yet, it would be nice to have numbers backing up these statements . – JoeTaxpayer Jun 14 '16 at 21:03
  • Really good answer. One small point - if one expects inflation to translate into profits growth, then "nothing else changes" might be overlooking the need for wage growth to match inflation, otherwise buying power is reduced and this would impact on profits for the largest part of the ecomomy - i.e., the consumer related industries. Also, bond yields are an important factor here. We currently have negative "real" yields with inflation being higher than bond yields, which appears to have a significant impact on valuations as investors chase yield. – Nick R Jun 15 '16 at 0:31
  • @NickR Good points. Inflation is a subtle concept as it affects profits/wages etc. Actually your comments also lead me to a significant omission on my part: as I have described them stocks are safer with respect to unexpected inflation than bonds and other nominal assets and thus views on future inflation could affect your desire for stocks. I omitted this point for brevity but it's quite true. – farnsy Jun 15 '16 at 21:34
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The answer would depend on the equities held. Some can weather inflation better than others (such as companies that have solid dividend growth) and even outpace inflation. Some industries are also safer against inflation than others, such as consumer staples and utilities since people usually have to purchase these regardless of how much $ they have.

In looking over the data comparing S&P 500 returns, dividends, and inflation, the results are all over the map. In the 50's the total return was 19.3% with inflation at 2.2%. Then in the 70's returns were 5.8% with inflation at 7.4 percent, leading one to think that inflation diminished returns. But then in the 80's inflation was 5.1%, yet the return on the S&P was up to 17.3%

Either way, aside from the 70's every other decade since 1950 has outpaced inflation (as long as you are including dividends; hence my first paragraph).

S&P 500: Total and Inflation-Adjusted Historical Returns

Also, the 7% average stock appreciation you mention is just that, an average. You are comparing a year-over-year number (7% inflation) with an aggregated one (stock performance over x number of years) and that is a misrepresentation and is not being weighted for the difference in what those numbers mean.

Finally, there are thousands of things that have an effect on the stock market and stocks. Some are controllable and others are not. The idea that any one of them, such as inflation, has any sort of long-term, everlasting effect on prices that they cannot outmaneuver is improbable. This is where researching your stocks comes in...and if done prudently, who cares what the inflation rate is?

  • That linked chart should open peoples eyes. +1 – Nick R Jun 15 '16 at 0:34

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