Inflation! Deflation!

Two words that strike fear into the hearts of investors.

Are such fears justified? Let’s take a look…

If we segment calendar year changes in the Consumer Price Index (CPI) into quintiles, we observe the following:

• The lowest equity returns have occurred in deflationary (quintile 1) and inflationary (quintile 5) environments.
• The highest equity returns have occurred in periods of low (quintile 2 & 3) to moderate (quintile 4) inflation.

Source Data for all tables herein: YCharts, BLS, Stern.NYU.edu/~adamodar

During years with the highest inflation (quintile 5):

• Stocks generated the lowest nominal returns, 4% on average, with 56% of years posting a positive return. The real equity returns, at -3.5%, were also the lowest.
• Many of the years represented in this quintile occurred during the 1970s (1970, 1973, 1974, 1975, 1976, 1977, 1978, and 1979) early 1980s (1980, 1981). Stagflation was the great concern of this period.
• Many of the worst stock market returns in this quintile occurred during years in which the economy was in recession (1969, 1973-74, 1981, 1990).

During years with the lowest inflation (quintile 1):

• Stocks generated an annualized return of 4.6% with 56% of years posting a positive return. The real equity returns, at 6.5%, were higher than the nominal returns due to the negative annualized CPI in this quintile.
• Many of the years represented were during the Great Depression (1929-1932) and the subsequent decade (1938, 1939, 1940). Deflation was the great concern during this period.
• Many of the worst stock market returns in this quintile occurred during years in which the economy was in recession (1929-1932, 1953, and 2008).

What’s left? The so-called “goldilocks” periods in which inflation was running neither too cold nor too hot (in a range between 1.2% and 4.7%). It was during these quintiles that stocks posted their best returns on both a nominal and real basis.

The “goldilocks” periods (quintiles 2-4) also contained fewer recessions and consequently a higher percentage of years in which stocks finished higher.

Which quintile are we in today?

With the CPI up 2.1% over the past year, we are right on the border of quintile 2 and quintile 3. While fears of inflation seem to be picking up in recent weeks, we’re still much closer to a deflationary environment than an inflationary one (side note: things can change in a hurry – CPI was 4.1% in 2007 before the 2008 deflationary collapse).

Source Data: St. Louis Fed (FRED).

The Federal Reserve seems to be of this opinion as well, with the Effective Fed Funds Rate of 1.42% still below inflation and far below its historical average of 4.86%.

Source Data: St. Louis Fed (FRED).

Does that mean stocks can’t go down as long as inflation stays where it is?

No. While the “goldilocks” quintiles have historically shown higher returns and more positive years than inflationary/deflationary regimes, there are a number of exceptions. Most recently, stocks declined in 2000 (-9.2%), 2001 (-11.9%), and 2002 (22.1%) with CPI registering 3.4%, 1.6%, and 2.5% during those years. With the exact same inflation numbers in 1995 (2.5%), 1996 (3.4%), and 1998 (1.6%) stocks finished higher by 37.6%, 23%, and 28.6%.

Which should tell you that the level of inflation is only one of many factors influencing equity returns. Much more important to short-term returns is sentiment (how much investors are willing to pay for a given level of earnings) and to long-term returns is valuation (how much investors are paying today relative to history).

Even if you were able to predict the level of inflation next year with precision, it would be impossible to use that figure in predicting the return of the stock market.