Oil prices are at nosebleed levels, and gasoline at the pump is as costly as it has ever been. Industrial commodity prices are surging, the dollar is weak, the federal budget deficit growing, and the nation is at war. Money is pouring into gold, Treasury inflation-indexed securities (TIPS), and other alternative investments. Inflation is in the air. Does that mean it's time to bail out of stocks?
Perhaps not. The conventional wisdom that inflation is bad for stocks in the short term is an observation largely shaped by the Baby Boom generation's experience with surging inflation in the 1970s. Economists agree that stocks do well compared with inflation over long periods of time, sometimes measured in decades. The sweep of market history shows that there are times when robust stock markets and rising prices go hand in hand. If stocks sell off because of an inflation scare, it could be a great opportunity to buy.
Indeed, inflation helped touch off the 10 best stock market years, measured by total return, of the 20th century, says Martin Fridson, a bond market specialist and author of the U.S. stock market history, It Was a Very Good Year (John Wiley & Sons). In 1915 an inflation panic swept the major industrial nations. World War I was under way in Europe, and war-related profits boomed in the U.S., then still a neutral nation. The U.S. stock market returned almost 36% in 1915, while inflation doubled from 1% in 1914 to 2% in 1915, and climbed to 12.6% in 1916. Similarly, in 1933 the Standard & Poor's 500-stock index returned 53.97%, even as wholesale prices jumped.
It was a truism of finance that good markets and rising prices went together until the 1960s. "Inflation, as everybody knows, is good for stocks," remarked the legendary Salomon Brothers bond market researcher Sidney Homer as late as 1967 in a speech. One reason is that except for periods of war, the American economy swung between price stability and deflation from the founding of the Republic to the early 20th century. Many household items, a meal, clothing, and other goods cost less in 1900 than in 1800. Historically, absent a runaway double-digit inflation rate, rising prices were considered good for business. British economist John Maynard Keynes captured the underlying dynamic in a 1923 essay on inflation and deflation: "It has long been recognized, by the business world and by economists alike, that a period of rising prices acts as a stimulus to enterprise and is beneficial to business men." Investors went along for the ride.
The default line in U.S. market history came during the Great Inflation of the post-World-War-II era. The double-digit price increases of the 1970s ravaged savings, hammered stocks, and destroyed the reputation of equities as a hedge against inflation. Yet the similarities between the economy of the 1970s and now are few and far between.
It's hard to see a sustained rise in prices in a world of fierce international competition and the accelerating trend toward outsourcing of blue-collar and white-collar jobs. To be sure, higher oil prices are a force driving fear of inflation these days. But studies of the last several oil price runups suggest that they act like a tax hike, draining consumers' pockets and depressing other sorts of spending. And it wasn't all that long ago that the Fed worried about deflation, a concern that won't go away with the producer price index up just 0.1% in February.
Interest rates will jump and stocks will crater if an inflation scare emerges and the Federal Reserve tightens monetary policy. The immediate reaction to the tightening may open up a buying opportunity for investors. The ability of companies to raise prices will stoke earnings, a signal that the economy is on the mend, and stocks could climb higher. By Christopher Farrell