I wrote a post last year about inflation and investments, where I concluded that stocks are a useful but sporadic hedge against inflation.  This was based on a fairly robust analysis of past U.S. stock returns and inflation rates going all the way back to 1871.  I found that stock returns were uncorrelated with inflation rates.  Further, stocks often provided decent returns after large spikes or dips in the inflation rate, even though one might assume these sorts of economic conditions would consistently spook investors out of the stock market.

I was pretty confident with my conclusions until I came across several articles that claim stocks are, in fact, a poor hedge against inflation.  Could my analysis have been all wrong?  I hate being wrong, so I conducted a more laborious analysis of stocks and inflation.  The time involved with this analysis is one of the main reasons it’s been so long since my last post.  Apologies to my regular readers, as few as you may be.

Why Should We Even Care?

The whole question of stocks and inflation may seem esoteric.  However, many investing gurus are concerned that current trends in strong corporate earnings, low unemployment, and wage pressures will lead to a new period of rising inflation.  Mindfully Investing recommends a stock-heavy portfolio for almost all individual investors.  So, if stocks aren’t a good inflation hedge, then that’s timely and potentially actionable news for us mindful investors.

One of the key tenants of mindful investing is patience, and exploring arcane but important topics like this can test that patience.  Despite the high boredom potential, I’m planning a series of posts to pull apart the Gordian knot of stocks as an inflation hedge.  If you’re feeling sleepy already and have developed some trust in Mindfully Investing, you could just skip to the conclusion at the end of this post.  And you can do the same when my follow-up posts on inflation and stocks come out.

Look What Happened in the 1960s

The first article that started me reassessing stocks as an inflation hedge was at Financial Times by Mathew C. Klein entitled, “No, Stocks Aren’t a Good Inflation Hedge. Try Bonds (Really)”.  The article presents an analysis of stock and bond returns during a period of increasing inflation in the late 1960s and early 1970s.  Beyond the hippies, drugs, free love, questionable fashions, civil rights, feminism, war, and the associated political shenanigans, this was also a tumultuous economic period.  Here’s the key figure from the Klein article.

The graph shows that from about 1964 to 1970 (circled in red) the annualized S&P 500 stock return slightly under performed the U.S. 10-year bond returns, assuming both investments were held for 10 years.  The annual inflation rate increased from about 1% to 6% in this period and continued up to 12% a few years afterwards.  Klein writes, “If [in 1964] you had known that the US was about to experience a long period of accelerating inflation, would you have bet on US Treasury bonds over US corporate equities?  It certainly doesn’t seem like the right plan, and yet [bonds] would have made you money for a surprisingly long time.”

First, let’s be clear on Klein’s point.  My last post on inflation presented considerable evidence that stocks can perform well during high inflation or deflationary periods, and Klein’s prudently not challenging that generic idea.  Here’s one graph from my last post illustrating the resilience of stocks during a wide range of inflation conditions; it’s based on data from Nobel Laureate Robert Shiller spanning 1871 to present.

Instead, Klein claims that the 1960s illustrate how bonds combat inflation better than stocks specifically during periods when inflation is rising substantially.  However, just my simple graph shows several exceptions when inflation was rising but stocks performed pretty well.  And it’s even hard to detect in my graph the supposed miserable performance of stocks in the late in 1960s, but if I squint, I kind of see Klein’s point.

Second, Klein is focused on the ramping inflation that was in store for someone investing around 1963 or 64.  While Klein’s graph looks compelling, it doesn’t give us any information on inflation rates.  It seems that a closer examination of both stock returns and inflation in the 1960s could clarify whether this weird time in U.S. history proves that stocks are a poor inflation hedge in general.

Stock Returns and Inflation from 1965 to 1975

This table shows the Shiller data from 1960 to 1980, which includes the decade from 1965 to 1975 plus five additional years on both ends to provide little wider perspective.

Whether you focus on nominal or real returns, stock investors experienced some really good and some really bad years over this period.  This was not a time of consistently dismal stock returns.  The results for any given investor were heavily dependent on exactly when they entered and exited the stock market.   Inflation jumped around quite a bit too, which belies the generalization that inflation was steadily increasing.

To estimate what an actual investor might have experienced, I calculated all possible combinations of start and stop years for a stock investor in the decade from 1965 to 1975.  Specifically, I calculated the Compound Annual Growth Rate (CAGR) of stocks and inflation if you started investing in 1965 and ended in 1966, 1967, 1968, etc.; started in 1966 and ended in 1967, 1968, 1969, etc.; and so forth.  This method produces 66 investing periods ranging from 1 to 10 years long, with the longest period representing the entire decade from 1965 to 1975.  The median duration across all 66 investing periods is just 4 years long.  At Mindfully Investing we generally advise investing in stocks for periods longer than 5 to 10 years.  So, the results for these 66 periods represent a relatively risky investment strategy during a pretty risky decade.

Despite the short timelines involved, this histogram of all the results shows that 80% of the 66 outcomes produced positive nominal annualized stock returns and about 40% produced returns above 5%.

Here are the same results on a real basis (adjusted for inflation), which shows that 40% of the 66 outcomes yielded positive real annualized stock returns and about 25% had real returns above 3%.  Perhaps more importantly, only the worst 10% of the results produced real losses lower than an annualized -10%.  And these worst-case outcomes all involved investing over very short periods of about 1 to 2 years; longer investing periods fared much better.

Although the most likely outcome was a slightly negative real return, during this period of rising inflation an investor still had a pretty good chance of achieving positive real stock returns.  And you had a low chance of a significant loss, despite the short timelines involved.

Extrapolating from the Example

Don’t get me wrong, the period from about 1965 to 1975 was pretty bad for stocks.  Using more standard measures, if you held your stocks for the full decade and then one more year into 1976, your annualized real return was essentially zero (although the nominal annualized return was about 5%).  And as Klein’s graph shows, bonds barely outperformed stocks in the first half of this decade, and stocks resumed outperforming bonds by a much wider margin in the second half and beyond.  So, it’s not like bonds represented a huge missed opportunity for the long-term stock investor.

In comparison, Klein’s graph shows the decade from 2000 to 2010 was miserable for stocks, even though inflation was uniformly low.  I held stocks throughout that decade, and the S&P 500 generated a paltry real annualized return of -1% (nominal +1%), but nobody points to inflation rates as the cause.  Klein’s graph shows that 1929 to 1932 was even worse for stocks.  But economic conditions leading to deflation were the problem in the early 1930s, not ramping inflation.

If anything, the ramping inflation in the 1960s and early 70s seems coincidental to stock performance in this period, with both reflecting larger economic troubles.  And despite those economic conditions, my analysis shows that stocks were still a pretty effective investment for many investors, depending on exactly when and how long they were invested.  Klein even points out that stocks were “so expensive” in the 1960s, which would seem to be a more direct, although less illuminating, reason for the stock market’s poor performance.

Conclusion

I don’t think Klein is willfully misrepresenting or cherry picking the data.  Bonds did in fact outperform stocks for a few years at the start of this period of rising inflation.  However, I think Klein made a leap that one example proves a rule and another leap that a short-term correlation implies a larger causation.  I continue to think that the 1960s were one episode that’s fairly consistent with the longer history of stocks and inflation, and that history suggests that stocks can be a useful but imperfect hedge against inflation.

After stepping back from these details, I realized that much of my disagreement with the Klein article probably boils down to the title.  To better attract clicks, internet titles tend to be somewhat hyperbolic and absolute.  In particular, it seems clearly false that bonds were a better hedge than stocks in this period, just by the simple fact that bonds only outperformed stocks for three years in this window, and only then by a very slim margin.

No investor can predict the future.  Dumping stocks in favor of bonds in the mid-1960s, or any time when inflation looms, seems like a highly imprudent “hedging” strategy for long-term investors.  Such a strategy ignores the copious evidence that stocks have handily outperformed bonds under a very wide range of historical market and economic conditions.

I also think part of the problem may be the widespread but vague use of the term “hedge”.  I’m somewhat guilty of that myself.  You can find a range of definitions for “hedge”, and in everyday usage, its meaning expands to cover almost anything other than a strong positive correlation between two metrics.  I’ll explore the confusion around inflation “hedges” in my next posts in this series.

Unfortunately for me, the Klein article is not the only one I found arguing against stocks as an inflation hedge.  In fact, some of these articles led me to quite a bit of scholarly work questioning stocks as an effective inflation hedge.  Reality checking this information involves an additional level of analysis that I’ll leave to my next post.