The Present and Past of Inflation

Stock markets are still relatively new to the grand scheme of things.

The way investors viewed stocks in the past is very different from what it is today.

Interest rates were much higher in the past. This meant that corporations in the late 19th and early 20th centuries had to offer dividend yields on their stocks that were higher than bond yields to entice people to invest in stocks.

Yield was one of the few valuation techniques that investors applied to financial markets.

Because of this yield ratio, there was a very simple valuation signal that would let investors know when stocks became too expensive. Whenever the dividend yield in the stock market dropped below the bond yield, stocks were too expensive and it was time to sell.

It was a very reliable signal, mainly triggered before the major accidents that took place in 1907 and 1929.

And then it stopped working.

Peter Bernstein explains in Against the Gods:

So it’s no wonder that investors bought stocks only when they generated higher income than bonds. And it’s no wonder that stock prices dropped every time stock income approached bond income.

Until 1959, that is. At that point, stock prices were rising and bond prices were falling. This meant that the ratio of bond interest to bond prices was skyrocketing and the ratio of stock dividends to stock prices was decreasing. The old relationship between bonds and stocks disappeared, opening up such a gap that, ultimately, bonds were outperforming stocks by an even greater margin than when stocks outperformed bonds.

The cause of this reversal could not have been trivial. Inflation was the main factor that distinguished the present from the past. From 1800 to 1940, the cost of living rose on average by only 0.2% a year, and actually fell on 69 occasions. In 1940, the cost of living index was only 28% higher than it was 140 years earlier. Under such conditions, owning assets valued at a fixed number of dollars was a delight; owning assets with no fixed dollar value was highly risky.

World War II and the economic environment that followed altered this relationship forever.

From 1941 to 1959, inflation averaged 4% per year. Prices doubled in that 19-year period.

This environment was not very good for bond investors. Bernstein points out that purchases of 10-year Treasury bonds in 1945 were worth 82 cents on the dollar in 1959. And that was before inflation.

That 82 cents could only buy half in 1959 than in 1949.

Meanwhile, dividends paid by corporations took off like a rocket in this same time period:

Stock dividends took off at a rapid rise, tripling between 1945 and 1959, with just one year of decline – and even that was just 2%. Investors no longer viewed stocks as a risky asset whose price and income moved unpredictably. The price paid for today’s dividend seemed increasingly irrelevant. What mattered was the growing stream of dividends that the future would bring. Over time, these dividends can be expected to exceed the interest payments on the bonds, with a proportionate increase in the equity value of the shares. The smart move was to buy stocks at a premium because of the growth opportunities and inflation protection they offered, and pass up dollar-denominated fixed-income bonds.

Investors are now well aware that equities provide long-term protection against inflation, but it makes sense that higher prices could cause a regime change in markets.

The fact that inflation is still a relatively new concept may help explain why it is so difficult to understand and why it makes people so angry.

We are just not used to inflation for a long period of time. Few people have experience dealing with the consequences of rapidly rising prices.

And while general inflation was extremely low back then, it’s not like it didn’t exist. It was just much more cyclical.

This is the annual inflation rate in the US from World War I to World War II:

The average rate of inflation was only 2% per year, but it was above 5% in almost 25% of that period. Approximately one in 7 years has inflation of 10% or more.

But there was also deflation more than a third of the time.

There was much more economic volatility with few sustained periods of calm.

Compare these numbers to the 40-year period since 1982.

Inflation has not been above 10% not once (yet). It was above 5% only 8% of the time, while deflation occurred in only 3% of all inflation readings.

However, the average annual rate was over 3%.

There’s a lot we still don’t understand about inflation, especially since there’s such a huge psychological component to prices and consumer spending.

Inflation could remain high for some time if governments continue to spend money or if the energy crisis worsens.

But it also wouldn’t surprise me to see severe disinflation or even deflation if the Fed goes overboard with interest rate hikes and we slip into recession.

Maybe we should have more economic volatility than we’ve had in the last 4 decades. Or maybe the pandemic is an outlier because there was so much economic weirdness going on.

It’s good to keep an open mind about what’s next in terms of prices and financial markets.

I’ll let Bernstein have the final say here:

The fact that something so unthinkable could occur has had a lasting impact on my outlook on life and investing in particular. It continues to color my attitude towards the future and has left me skeptical about the wisdom of extrapolating from the past.

Michael and I talk about inflation and more in this week’s Animal Spirits video:

Additional reading:
The worst-case scenario of cast inflation

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