Why Stocks Are the Best Hedge Against Inflation

A general assumption has formed among many in the personal finance realm that stocks do well during times of low inflation, and commodities are the go-to investment during times of high inflation. But is this even true? While there’s a case to be made for holding commodities during times of high inflation, long-term performance strongly favors stocks.

While stocks may not react positively during protracted times of high inflation, it’s clear that investing in stocks will enable you to stay ahead of the inflation curve in the long run.

The History of Inflation

While there have been times in the past century when inflation has gone to double-digit levels, for the most part it’s been pretty well-behaved. Between 1928 and 2016, the average annual rate of inflation has been 3.05 percent. That average factors in the years in which inflation exceeded 10%, which is to say that in most years, the actual rate of inflation has been notably less than 3 percent. For instance, last year (in 2016), the inflation rate was only 1.26 percent.

That certainly describes the inflation experience of the past 25 years. Data from the Minneapolis Fed show that while inflation frequently ran at double-digit annual rates during the 1970s and early 1980s, as well as during the two world wars, it has rarely moved above 3% since 1992.

inflation

While it’s always possible that we can experience a bout of inflation that goes either close to or into double digits, the long-term trend is on the lower side. In the meantime, the common practice of estimating inflation at 3% per year is well supported by the data.

What about Gold and Commodities?

These are the most commonly cited investments whenever the topic of inflation arises. Most of the confidence that gold and other commodities are the ultimate investment hedges are based on the experience of the 1970s. During that decade, price levels jumped dramatically. Sure, stock prices languished, but most commodities rose in price substantially.

For example, gold closed out 1970 with a market price of $38.90 per ounce (though the official exchange rate was $35 per ounce). By the end of 1980, the price closed out at $594.90 per ounce. But that was not before it had topped out at well over $800 per ounce earlier that same year (the gold/dollar link officially ended in 1971, so there was no longer an official price). That means that from 1970 through the 1980 peak price, the cost of gold rose more than 20 times.

The situation is similar with oil. In 1970, the average annual price of oil was $3.39 per barrel. But in 1980, the average annual price rose to $37.42 per barrel. This means that the price of a barrel of oil increased by a factor of more than 10 during the 1970s.

Those price increases are dramatic, and they underscore why there’s so much faith in the connection between commodities and inflation. But even if we assume that the connection between commodities inflation is symbiotic, the connection only seems to apply during times of very high inflation.

Learn More: Is Buying Gold and Silver a Good Investment?

For example, after the high inflation 1970s and early 1980s, the price of gold steadily declined for nearly two decades. In fact, it reached a low of $252.80 an ounce in 1999, at the height of the dot-com boom. Yet, during that same timeframe, inflation continued (albeit at a much lower rate). This means that gold not only declined substantially based on its nominal price, but even considerably more when inflation gets factored into the equation.

Even if the 1970s are a reliable standard of investment performance during times of inflation, it’s clear that commodities like gold and oil react positively only during such extremes. During the normal course of events, when inflation is much lower, both commodities languish.

 

The Long-term Performance of Stocks

Over the very long-term, stocks have produced an average annual return of return of 9.53%, when calculating from 1928 through 2016. (This is the geometric average, since it’s based on the fluctuating values that stock price changes create, based on S&P500). That return matches up very favorably with the average annual inflation rate of 3.05% over the same timeframe.

But what about those years when inflation really spiked – did the stock market take a big hit?

Not necessarily. The annual inflation rate for 1942 – at the height of World War II – was 10.9%. But the return on stocks in the same year was 19.17%. Similarly, in 1980, when inflation reached an all-time postwar high of 13.5%, stocks returned 31.74% in the same year. Clearly, inflation is not necessarily a negative for stocks.

On the flip side, we shouldn’t conclude that inflation is necessarily good for stocks either. For example, the 1970s featured robust inflation and a lackluster performance by stocks. The ultimate take-away? Stocks have performed much better against inflation than is commonly assumed, at least over the very long term.

Stocks Work Best With the Much More Common Gradual Inflation

Sure the evidence may support that commodities do well during times of extreme inflation, like the 1970s. However, we can hardly consider them to be all-weather investments. Gold and oil performed extremely well during the inflation-ridden 70s, but they clearly have not done as well since. This is especially true when you consider that in inflation-adjusted terms, both commodities are trading well below their 1980 peaks.

Related: Real Estate vs. Stocks — Where Should Your Nest Egg Go?

Stocks, on the other hand, have prospered since the 1970s. The Dow Jones Industrial Average closed out 1980 at 964. However, it is currently flirting with 21,000. That means that stocks have risen by a factor of more than 20 in the low inflation years since 1980.

It’s clear that stocks work best with gradual inflation. You know, the type that has dominated the economy since the early 1980s. The longer-term trend – going all the way back to 1928 – provides even more evidence of this. The Dow began 1928 at 200, for example. Based on today’s prices, it is now trading at more than 100 times that level.

That means that over the very long-term, stocks are the better inflation hedge.

What if Inflation Heats Up?

Until now, we’ve been making the case for stocks as the preferred long-term investment hedge. The data certainly supports that conclusion. But at the same time, it’s undeniable that there have been times in the past 100 years when inflation has risen to uncomfortable levels. Stocks have not done as well during those times. And there’s strong evidence that other assets, like gold and oil, have been better performers.

So, what’s the best investment strategy if you suspect that another surge of inflation is coming?

It appears that the best strategy is to maintain a strong stock position, despite an increase in inflation. But there’s also a strong case to be made for investing at least some of your portfolio in gold and oil-related investments. And, of course, this can more easily be done by investing in stocks engaged in gold and oil production. It’s easier and more convenient than owning gold itself and certainly more practical than buying and storing barrels of oil.

Read More: Setting Up the Perfect Asset Allocation

Realistically, since you can invest in both gold and oil in the form of stocks, you can simply allocate a minority percentage of your portfolio to those sectors. That would enable you to stay ahead of inflation, whether it’s the more common gradual variety, or if it gets up to those disturbing double-digit levels like we saw in the 1970s.

We have yet to develop a crystal ball to show us what the future hold for stocks or even the American dollar. Allocating your portfolio, planning to invest for the long-term, and ensuring that you stay out of debt are the best ways to make sure your money continues to work for you… no matter what inflation brings.


Topics: Investing

Leave a Reply