Stocks, Inflation, and the Strategic Implications

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bjr89
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Stocks, Inflation, and the Strategic Implications

Post by bjr89 » Mon Oct 22, 2018 11:50 pm

Something I've struggled with lately is the general consensus among the macro / risk parity community that stock prices and inflation surprises have an inverse relationship.
Image
Of course, traditionally, stocks were viewed as inflation hedges (they can raise prices, they own tangible property, etc), but Bridgewater, AQR, and practically everyone else in macro risk factor world are notable for saying that equities decline with rising inflation and that one therefore needs commodity exposure in order to achieve balance. Maybe stocks get hurt because of the difficulty of managing a business in real terms during high inflation or rising discount rates. But something as simple as a quick google search into Wiemar Republic or the Venezuelan hyperinflations will teach you that their stock markets appreciated accordingly. Now I know here at the Bogleheads that commodities are viewed negatively from a strategic perspective and that I may be posing this question to the wrong community since I'm unlikely to get much disagreement... but what's with the disconnect here? To me, it sorta seems like stocks belong in the top two boxes and nominal bonds in the bottom two boxes, eliminating the need for things like commodities with zero real return. Perhaps Bridgewater has found some statistical inverse relationship in the short run, but isn't Venezuela evidence to the contrary? What do you guys think?

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JoMoney
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Re: Stocks, Inflation, and the Strategic Implications

Post by JoMoney » Tue Oct 23, 2018 2:13 am

I would expect that during a period of inflation, interest rates would rise. If interest rates rise, stocks should be discounted on a relative basis as well (although rising inflation could be a sign of a growing economy offsetting some of this as well). This doesn't play out well in the short-term if you need more money now, but over a longer period the higher interest rates (and discounting on stocks) should mean commensurately higher future returns.
I'm not a fan of commodities, the expenses and volatility for something with an expectation of zero real return seems silly to me. That's not really an "investment" nor a good emergency fund.
I prefer to stick to a simple portfolio of stocks and short-term bonds to cover any near term expense. I don't expect that the short-term bonds will provide a real return either, but they should be offering something competitive with inflation and they're more reliable in an emergency when I might need the money.

From what I've read, Venezuela's stock market did have a massive uptrend with the inflation there, problem is that (at least according to one article I saw) the 600% gain in the stock market was matched with somewhere between 127% to 43,000% inflation (hard to pinpoint precisely). I'm not sure what to conclusions to draw from that, other than the economy is in shambles.
I wonder what happens to traded commodities if the government enforces price controls and mandates they trade at a fixed price. It's happened in the U.S. during an economic crisis. In 1933 U.S. citizens were mandated to turn over all gold coin, bullion, and certificates at the rate of $20.67 an ounce.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Stocks, Inflation, and the Strategic Implications

Post by typical.investor » Tue Oct 23, 2018 2:31 am

Not the most informed reply and for that I apologize, but I thought too that Vanguard suggested commodity futures which were colleralized with t-bills.

As such, it’s to combat inflation- both expected and unexpected over the shorter term.
Our analysis suggests that commodity futures and T-bills can provide an effective partial hedge against inflation, particularly in the near term. Commodity futures have historically provided returns that tend to be positively related to unexpected inflation, while T-bills have provided returns positively related to expected inflation. Because most investments in commodity futures are fully collateralized by T-bills, investors may potentially use these futures as a hedge against both expected and unexpected inflation. Although many traditional asset classes have not provided a significant inflation hedge over the short and medium term, over the long term
they may earn high enough returns to overcome the erosion in purchasing power caused by inflation. Holding a well-diversified portfolio can help to provide both reasonable long-term returns as well as some protection from inflation.
Not sure how expensive that’d work out as insurance if inflation didn’t materialize or if going short term tips/ nominals would be better.

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Re: Stocks, Inflation, and the Strategic Implications

Post by not4me » Tue Oct 23, 2018 9:03 am

bjr89 wrote:
Mon Oct 22, 2018 11:50 pm
To me, it sorta seems like stocks belong in the top two boxes and nominal bonds in the bottom two boxes, eliminating the need for things like commodities with zero real return. Perhaps Bridgewater has found some statistical inverse relationship in the short run, but isn't Venezuela evidence to the contrary? What do you guys think?
Not sure I follow the question exactly & would appreciate any expansion. When you talk about the "need" .... are you suggesting they might be "needed" to improve total return? reduce risk? For what objective are they presumed to be needed in this discussion?

I'm not that familiar with Venezuela, but will share a perspective that may only serve to give others a target to shoot at. I don't see it as evidence of much of anything except maybe government overreach. Here's why. First, I have what may be a minority opinion on inflation in that I don't see it as a monolithic thing. Inflation is basically a result of an supply/demand imbalance. There are different causes/effects of inflation that come from imbalances of labor (wage inflation), commodities, currencies etc. Speaking of commodities, they are usually (not always) priced in US dollars & so there are differences in those areas where the USD is not the local currency than in US.

Very simplistic terms (as I understand it), Venezuela's economy was overwhelmingly tied to ONE commodity -- oil. They exported oil, were paid in USD, & then imported much of the stuff they consumed. I believe they had a state-owned oil operation. As things went well, their political leanings got overly exuberant on worker benefits & workers got accustomed to that. Then, the world oil price fell. Fewer dollars coming in, less ability to import, yet heightened consumer expectations. The government tried to intervene & use currency pegs, price controls, printing money, etc. Basically, created a mess. Whether the stock market there was up in nominal terms, I really don't know but even if so I don't think it has bearing. Maybe others will correct my misstatements...

I believe that central banks intervention has skewed commodity prices in recent years & that has torpedoed any chance that a managed futures strategy ever had. (And to emphasize, those would be on multiple commodities & in USD) That coupled with the state of the job market has kept inflation at bay. As both of those change, the future may look different than recent past...or maybe not. But I don't think Venezuela gives any indication

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Re: Stocks, Inflation, and the Strategic Implications

Post by heyyou » Wed Oct 24, 2018 2:29 am

Often, whatever would have worked well on a previous problem, is not a good solution in the following period or for the future repeat of a previous problem. Some of this can be attributed to stock price crashes (similar symptoms) but occurring after different stock run-up reasons. Risk and reward dictate that investing gains will not be easy, so if they do look as if they will be easy, they might be small or negative.

Commodities exposure is a great inflation buffer idea, but the execution and marketing of one of the available choices (funds of collateralized commodities futures (CCFs)) for that exposure, has not been a good investment. Just put PCRIX in a Google search and set the time on the graph at maximum. Note the $20 initial issue price as shown is after the true $10 initial price was adjusted by a 2 to 1 reverse split to help the current $6 shares not look like the original $10 shares now worth only $3 each.

CCFs were marketed as producing income in numerous different market environments, but the future held a long period of near zero interest rates that did not fit any of those income situations inherent in the CCF fund design. Driving forward while using only the rear view mirror, did not work for the CCF fund investors.

What did work was too simple to suit the Main Street investors, nor was profitable for Wall Street marketers. Long term owning of equities has easily outgrown previous inflation, after the inflation occurred, for those with patience, but there is little patience on Main Street, and only low profits from buy and hold accounts for the big brokerages. Simplicity is often touted at this board, but it is the lesser-mentioned patience that is necessary for those simple portfolios to be so profitable over long periods--with investors accepting the current and subsequent risks to eventually get those substantial rewards in the distant future.
More succinctly from poster Nisiprius, "You have to take the risks to get the rewards."

bjr89
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Re: Stocks, Inflation, and the Strategic Implications

Post by bjr89 » Wed Oct 24, 2018 4:05 am

Sorry if I wasn't clear in what I was asking. Basically I'm just wondering why the risk parity community thinks stocks have an inverse relationship with inflation, when it's clear from both basic logic and historical examples such as hyperinflations that they in fact are positively related. Typical risk parity managers have equal parts risk exposure to stocks, bonds, and commodities. They believe that commodities are essential because both stocks and bonds respond negatively to inflation. I'm just wondering why stocks don't play the inflation hedging role of commodities, eliminating their need to own commodities altogether.

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siamond
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Re: Stocks, Inflation, and the Strategic Implications

Post by siamond » Wed Oct 24, 2018 4:21 am

bjr89 wrote:
Wed Oct 24, 2018 4:05 am
Basically I'm just wondering why the risk parity community thinks stocks have an inverse relationship with inflation, when it's clear from both basic logic and historical examples such as hyperinflations that they in fact are positively related.
As heyyou mentioned, is is probably a matter of timeframes. If you're expecting stocks to catch up with inflation within a year, you will be disappointed and might observe null or negative correlation. While TIPS or other 'real' assets are supposed to react relatively quickly. Now if you're patient enough, stocks should catch up with inflation (and more) for the reasons that you mentioned (empirical and basic logic) and you should see the positive correlation. Personally, I have a high equity exposure in my asset allocation, and I plan over the coming decades (not over the next quarter!), so I am fully happy with equities as an inflation hedge. The risk parity community probably operates with a much shorter timeframe...

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Re: Stocks, Inflation, and the Strategic Implications

Post by Valuethinker » Wed Oct 24, 2018 5:28 am

siamond wrote:
Wed Oct 24, 2018 4:21 am
bjr89 wrote:
Wed Oct 24, 2018 4:05 am
Basically I'm just wondering why the risk parity community thinks stocks have an inverse relationship with inflation, when it's clear from both basic logic and historical examples such as hyperinflations that they in fact are positively related.
As heyyou mentioned, is is probably a matter of timeframes. If you're expecting stocks to catch up with inflation within a year, you will be disappointed and might observe null or negative correlation. While TIPS or other 'real' assets are supposed to react relatively quickly. Now if you're patient enough, stocks should catch up with inflation (and more) for the reasons that you mentioned (empirical and basic logic) and you should see the positive correlation. Personally, I have a high equity exposure in my asset allocation, and I plan over the coming decades (not over the next quarter!), so I am fully happy with equities as an inflation hedge. The risk parity community probably operates with a much shorter timeframe...
Stocks are very volatile and thus pay high real rates of return in an efficient market.

Thus in the long run they beat inflation.

That is not guaranteed. In recent periods of high inflation like 1968-1980 they did not do so.

At a guess, because rising inflation tends to bring rising interest rates, it's not good for equity performance. Also inflation causes a long run deterioration in corporate earnings due to the interactions between the conventions of accounting (historical cost) and the tax system (nominal not real income and gains are taxed).

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Re: Stocks, Inflation, and the Strategic Implications

Post by Ron Scott » Wed Oct 24, 2018 8:32 am

I suspect the so-called All Weather portfolio was developed through selective backtesting as a product with a unique storyline. In that regard it is similar to an active fund and buyers will have similar experience vs. a BH 2-fund approach.

Adding commodities as a key asset class next to stocks and bonds probably stems from the originators’ trading backgrounds and undoubtedly adds mystique for the average retail investor.

I know this will sound negative, but I see this as a classic Guru play. The Guru creates a new paradigm with its own language, rules, storied history and lofty promises. The followers sit at the knees of the Guru and try to master the complexity, add little nuggets to the game, argue over inconsequential fine points, and—most importantly—BUY.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

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Re: Stocks, Inflation, and the Strategic Implications

Post by nisiprius » Wed Oct 24, 2018 8:56 am

Beginning investors are often told a simplistic story about stocks and inflation. The reality is more complicated. I think it is very misleading to call stocks an inflation "hedge." What has been true is that stocks have delivered a large real return, that has usually been enough to overcome inflation by brute force over periods of about 20 years--despite large fluctuations in real value.

In The Intelligent Investor, 4th ed., 1973,
Benjamin Graham wrote:(p. 20) On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period 1966-1970. The rise in the cost of living was 22%... but both stock earnings and stock prices have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.
Benjamin Graham wrote:(p. 23) ....if the investor concentrates his portfolio on common stocks he is every likely to be led astray either by exhilarating advances or by distressing declines. This is particularly true if his reasoning is geared closely to expectations of further inflation.
The famous Businessweek cover and article, "The Death of Equities," is almost always misrepresented. It is portrayed as a piece of foolish pessimism, ironically appearing just at the start of a bull market. In reality, the full title of the article was "The Death of Equities: How inflation is destroying the stock market" and it was not expressing pessimism about the future, it was reporting a current fact. After over a decade of zero or lower real return, investors had largely lost interest in stock investing and were flailing around looking for what we would now call "alternatives." Brokerages were in desperate financial trouble, many going bankrupt; they lacked the money to computerize, back-office operations were a shambles, there were incidents of missing stock certificates and rumors of underworld involvement... and that is why the SIPC was created.

(I am pretty skeptical about risk parity, as I am of all strategies involving long-short portfolios and leverage. One is always being told of stellar results being obtained by hedge funds, yet when what are allegedly the same strategies are embodied in mutual funds and managed by professionals of ordinary ability, the results don't seem to warrant the risk. I think it was just plain reckless of Wealthfront to default 20% of their investors' portfolios out of simple long-only ETFs--with mild factor tilts--and into their own risk parity mutual fund.)
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Re: Stocks, Inflation, and the Strategic Implications

Post by Valuethinker » Wed Oct 24, 2018 10:02 am

nisiprius wrote:
Wed Oct 24, 2018 8:56 am
Beginning investors are often told a simplistic story about stocks and inflation. The reality is more complicated. I think it is very misleading to call stocks an inflation "hedge." What has been true is that stocks have delivered a large real return, that has usually been enough to overcome inflation by brute force over periods of about 20 years--despite large fluctuations in real value.

In The Intelligent Investor, 4th ed., 1973,
Benjamin Graham wrote:(p. 20) On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period 1966-1970. The rise in the cost of living was 22%... but both stock earnings and stock prices have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.
Benjamin Graham wrote:(p. 23) ....if the investor concentrates his portfolio on common stocks he is every likely to be led astray either by exhilarating advances or by distressing declines. This is particularly true if his reasoning is geared closely to expectations of further inflation.
The famous Businessweek cover and article, "The Death of Equities," is almost always misrepresented. It is portrayed as a piece of foolish pessimism, ironically appearing just at the start of a bull market. In reality, the full title of the article was "The Death of Equities: How inflation is destroying the stock market" and it was not expressing pessimism about the future, it was reporting a current fact. After over a decade of zero or lower real return, investors had largely lost interest in stock investing and were flailing around looking for what we would now call "alternatives." Brokerages were in desperate financial trouble, many going bankrupt; they lacked the money to computerize, back-office operations were a shambles, there were incidents of missing stock certificates and rumors of underworld involvement... and that is why the SIPC was created.

(I am pretty skeptical about risk parity, as I am of all strategies involving long-short portfolios and leverage. One is always being told of stellar results being obtained by hedge funds, yet when what are allegedly the same strategies are embodied in mutual funds and managed by professionals of ordinary ability, the results don't seem to warrant the risk. I think it was just plain reckless of Wealthfront to default 20% of their investors' portfolios out of simple long-only ETFs--with mild factor tilts--and into their own risk parity mutual fund.)
https://research-doc.credit-suisse.com/ ... 3R5kq7g%3D

"Don't confuse inflation beating with inflation hedging" page 15 of the above document, by Elroy Dimson and Paul Marsh of Triumph of the Optimists fame.

We are on a page re equities as an inflation hedge.

Risk parity? I still can't get my head around it. I think that Portfolio Insurance, which was instrumental in the Crash of 1987, was also de facto a leverage strategy (virtually anything with options is - the whole point of options is that they give the holder leverage, and a seller/ writer an interest-like return for being the other side of the contract).

But leverage is a very dangerous thing in this world -- for investing. Because debt has to be repaid, it has term (or tenor). And thus, you can have to repay your debts before your other assets have recovered enough in value to repay them easily - the margin call. That is the centrepiece of every financial crash in history that I know of (even the dot com bubble had huge amounts of telecom and media company debt associated with it, as well as vendor finance by hardware and software companies to dot com customers).

(mortgages work because they are very long term debts, secured against either a rent (for an investment property) or a job/ labour income (for owner occupied) - but of course you can get caught, there, too, if the fall in housing prices outlasts your ability to repay the debt).

Warren Buffett periodically reminds people of this, I think, in his commentary re risk. He makes very great usage of leverage (via his insurance company "float" of premiums received but not paid out as claims) but is super cautious of where he invests his money ("don't lose money") and keeps a large cash liquidity balance on hand. A mutual fund manager just cannot do that - because it would take her portfolio too far off benchmark.

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Re: Stocks, Inflation, and the Strategic Implications

Post by alex_686 » Wed Oct 24, 2018 10:26 am

bjr89 wrote:
Wed Oct 24, 2018 4:05 am
Sorry if I wasn't clear in what I was asking. Basically I'm just wondering why the risk parity community thinks stocks have an inverse relationship with inflation, when it's clear from both basic logic and historical examples such as hyperinflations that they in fact are positively related. Typical risk parity managers have equal parts risk exposure to stocks, bonds, and commodities. They believe that commodities are essential because both stocks and bonds respond negatively to inflation. I'm just wondering why stocks don't play the inflation hedging role of commodities, eliminating their need to own commodities altogether.
For first order effects, stocks are a good hedge against inflation. Inflation should not affect the economic value of a real productive economic assets.However, let us ask why we have unexpected inflation in the first place. Unexpected inflation can signal that the economy is under stress.

A good example would be the oil shocks of the 70s. Supply of oil falls, oil shoots up in price, oil is a critical bit that underpins a good portion of the economy, the economy is in chaos as it retools. Note, separate out inflation from the economic chaos and equities were still a good hedge against inflation. It was the underlying real economic issues that cause stocks to underpreform.

As a counter example look at the unexpected increased inflation of the 90s. The economy was running flat out, and inflation was caused because the economy was running out of key inputs - like labor. In this case not only were stocks a good hedge against inflation and provided great returns.

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siamond
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Re: Stocks, Inflation, and the Strategic Implications

Post by siamond » Wed Oct 24, 2018 10:55 am

Valuethinker wrote:
Wed Oct 24, 2018 10:02 am
"Don't confuse inflation beating with inflation hedging" page 15 of the above document, by Elroy Dimson and Paul Marsh of Triumph of the Optimists fame.
Yeah, well, better come back to the full quote, and you'll see that they might not have meant what you meant... The following comes from the Credit Suisse Investment Returns YearBook 2017. The slides you quoted were meant to illustrate the document.

Finally, as for equities, they arguably offer a degree of insulation from some of these challenges.
Their earnings and dividend streams have by their nature an inflation linking. Moreover, in a
historical context, the yield comparisons of equities relative to bonds are not stretched, at a time
when investors have seemingly spent the best part of a decade focusing on deflation or
disinflationary hedges. There is precedent for moves from disinflation to mild inflation providing a
favorable environment for equities that would justify a long overdue asset allocation switch in
favor of equities versus bonds. However, a full examination of inflationary periods in the
Yearbook provides a reminder that the term "inflation hedge" can be something of a misnomer.
If the term "hedge" is used to portray a price moving in the opposite direction to another,
equities do not necessarily fit this bill in a progressively higher inflation world.
The asset
allocation decision becomes a relative not an absolute game.


Let us parse the two sentences I emphasized. The first one is plain simple logic, the fundamental drivers of stocks total returns are indeed linked to inflation. Trouble is this is a signal that can be lost in noise (e.g. valuation vagaries, manias, panics, etc), sometimes for years. The second statement points out that there is no short-term correlation between stocks and inflation (prices moving in direct/immediate opposition), so if one defines inflation hedge as a short-term risk mitigation mechanism, one will be disappointed with stocks. I think we all agree on this.

I would NOT define 'inflation hedge' in such a way though. Personally, I primarily care about the trajectory in the mid/long-run. And the combination of empirical data and plain logic leaves me satisfied enough about the stocks hedging properties. While acknowledging that the noise is powerful enough that there is no guarantee this will work within a few years, and sometimes longer.

Valuethinker
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Re: Stocks, Inflation, and the Strategic Implications

Post by Valuethinker » Wed Oct 24, 2018 11:06 am

siamond wrote:
Wed Oct 24, 2018 10:55 am
Valuethinker wrote:
Wed Oct 24, 2018 10:02 am
"Don't confuse inflation beating with inflation hedging" page 15 of the above document, by Elroy Dimson and Paul Marsh of Triumph of the Optimists fame.
Yeah, well, better come back to the full quote, and you'll see that they might not have meant what you meant... The following comes from the Credit Suisse Investment Returns YearBook 2017. The slides you quoted were meant to illustrate the document.

Finally, as for equities, they arguably offer a degree of insulation from some of these challenges.
Their earnings and dividend streams have by their nature an inflation linking. Moreover, in a
historical context, the yield comparisons of equities relative to bonds are not stretched, at a time
when investors have seemingly spent the best part of a decade focusing on deflation or
disinflationary hedges. There is precedent for moves from disinflation to mild inflation providing a
favorable environment for equities that would justify a long overdue asset allocation switch in
favor of equities versus bonds. However, a full examination of inflationary periods in the
Yearbook provides a reminder that the term "inflation hedge" can be something of a misnomer.
If the term "hedge" is used to portray a price moving in the opposite direction to another,
equities do not necessarily fit this bill in a progressively higher inflation world.
The asset
allocation decision becomes a relative not an absolute game.


Let us parse the two sentences I emphasized. The first one is plain simple logic, the fundamental drivers of stocks total returns are indeed linked to inflation.
Yes. Stocks are a real asset so they are better than a nominal asset. But the correlation with inflation is anything but perfect.

There are a few of reasons for this:
- companies may not be able to pass on the inflation they experience in input prices - that means someone else in the economy is getting that benefit, but they may not be a listed company
- there is a drag on investment by companies because of 1). historic cost depreciation - companies will tend to underinvest in new assets (the replacement cost will be rising) 2). even if we assume there is no money illusion (that companies and shareholders correctly adjust for this), there is a tax drag, because the tax allowance is based on historic cost of assets - they don't get credited in their taxes with the full costs of replacing their assets
- rising inflation tends to bring rising real interest rates due to Central Bank tightening and then that makes equities less attractive to other alternatives

(there is an offsetting effect, and this may in part explain the value stock effect as these tend to be more highly leveraged companies. If a company has long term fixed rate debt, then rising inflation is a *good* think for shareholders.)

(If I have a bias, it's because I sat in a room where Elroy Dimson told us that stocks were not a good inflation hedge. That was a long time ago, though ;-)).
Trouble is this is a signal that can be lost in noise (e.g. valuation vagaries, manias, panics, etc), sometimes for years. The second statement explains that there is no short-term correlation between stocks and inflation (prices moving in direct/immediate opposition), so if one defines inflation hedge as a short-term risk mitigation mechanism, one will be disappointed with stocks. I think we all agree on this.
Yes but it might also be true in the long term. As it was in the 1970s - stocks were a lousy inflation hedge. It was only when inflation looked well and truly on a downward trend that the bull market began (probably because real interest rates were falling from all time highs, and the economy generally was recovering -- loose monetary policy tends to bring bull markets).
I would NOT define 'inflation hedge' in such a way though. Personally, I primarily care about the trajectory in the mid/long-run. And the combination of empirical data and plain logic leaves me satisfied enough about the stocks hedging properties. While acknowledging that the noise is powerful enough that there is no guarantee this will work within a few years, and sometimes longer.
Commercial property would do it better. So would TIPS (and ibonds to the extent I understand US ibonds).

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Re: Stocks, Inflation, and the Strategic Implications

Post by siamond » Wed Oct 24, 2018 11:14 am

Valuethinker wrote:
Wed Oct 24, 2018 11:06 am
Stocks are a real asset so they are better than a nominal asset. But the correlation with inflation is anything but perfect.
I think this is a case of glass half-empty glass half-full interpretation... Personally, as long as there is a solid self-correcting mechanism, I am happy enough and will be patient (I hope!), but I realize that this doesn't satisfy everybody. And I do agree with your two sentences, so let's leave it at that! :wink:

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Re: Stocks, Inflation, and the Strategic Implications

Post by Valuethinker » Wed Oct 24, 2018 11:35 am

siamond wrote:
Wed Oct 24, 2018 11:14 am
Valuethinker wrote:
Wed Oct 24, 2018 11:06 am
Stocks are a real asset so they are better than a nominal asset. But the correlation with inflation is anything but perfect.
I think this is a case of glass half-empty glass half-full interpretation... Personally, as long as there is a solid self-correcting mechanism, I am happy enough and will be patient (I hope!), but I realize that this doesn't satisfy everybody. And I do agree with your two sentences, so let's leave it at that! :wink:
Happy to take the disagreement as being a shading. However I did dig out below (see IMF paper) a good (if not completely up to date) summary of the evidence and theories as to why.

I also remember the 1970s, and equities failing to keep up with inflation.

https://ageconsearch.umn.edu/bitstream/ ... hedges.pdf gives you correlations from US data since 1870s.

https://ftalphaville.ft.com/2015/05/06/ ... ds-really/

http://www.lazardnet.com/docs/sp0/3120/ ... search.pdf
In this paper we examine the suitability of equity investments to protect against the loss of value in inflationary or deflationary
environments. In our view, the role of equities as an inflation hedge is a fundamental question that cannot be
answered concisely. On one hand, in inflationary periods real returns from stocks are greater than those of bonds and
are almost always positive. On the other hand, the inflation hedge is limited, explained by the negative correlation of
real equity returns and inflation: the higher the inflation, the lower the real return on stocks
. The decline of real returns
on equities in the face of rising inflation can be strongly influenced by risk-averse investors. In high and volatile inflation
scenarios, investors become more risk averse and willing to pay lower prices in the stock markets.
See the underlined point.

https://www.imf.org/external/pubs/ft/wp/2009/wp0990.pdf
C. Corporate Equity
Conventional finance theory holds that equities should provide an effective hedge against
inflation as they represent a claim on the dividend stream of real assets. In other words, at the
aggregate level and in the long run, the corporate sector will pass on inflation in the form of
higher prices; see Mishkin (1992) and Boudoukh and Richardson (1993).
The experience of the 1970s, a period during which inflation rose and most of the major
equity markets suffered negative real returns, triggered a reappraisal of this view with notable
contributions including Bodie (1976), Jaffe and Mandelker (1976), Fama and Schwert (1977)
and Solnik (1983). The extent to which these developments came as a surprise is
encapsulated by Bodie’s remark that “this negative correlation leads to the surprising and
somewhat disturbing conclusion that to use common stocks as a hedge against inflation, one
must sell them short”.7


A range of competing hypotheses then emerged, attempting to explain
these relationships, four of which have endured: tax effects; inflation illusion; the proxy
hypothesis; and the equity risk premium.

We also consider recent contributions which indicate that, over the very long run, equities are
an effective inflation hedge, as well as other analyses which focus on the causality of
inflation.

5
Dudley (1996) estimates that the average difference between CPI inflation and the employment cost index
(ECI) that best expresses the rise in actual liabilities of a US pension fund was 1.3 percent during the period
June 1981–October 1996, or a cumulative 19.3 percent.
6
Dudley concludes that inflation-linked bonds offer an advantage to investors only when inflation rises while
real interest rates fall, a situation that occurred in 1973–1975, or generally in periods of “lax monetary policy
and monetary stress.”
7
Bodie (1976), p. 469.
7
Tax effect
The “tax effects” hypothesis was proposed by Feldstein (1979) and Summers (1981).
According to this analysis, rising inflation causes firms to report spuriously high profits due
to certain characteristics of the tax code, such as historical cost depreciation of assets and
methods of inventory valuation that can increase accounting earnings.8


This increases the
firm’s effective tax burden, reduces real profits, and leads to a decline in the valuation of the
firm’s equity through lower returns
. Although Summers (1981) and Poterba and Summers
(1984) provide evidence in support of this hypothesis, the subsequently poor empirical
performance of the q-model of investment has led the literature to focus more on alternative
explanations.

Inflation illusion

A more controversial hypothesis that raises doubts regarding market efficiency is “inflation
illusion”, proposed by Modigliani and Cohn (1979). This theory argues that investors commit
two inflation-induced errors: using nominal instead of real interest rates when capitalizing
firms’ expected real profits; and failing to recognize the implicit real capital gain that accrues
as a result of the depreciation in nominal liabilities, even though the decline in reported
profits for firms facing higher nominal interest payments is considered.

Proxy hypothesis

The “proxy hypothesis” suggests that the inverse correlation between equities and inflation is
spurious because inflation is acting as a proxy for the real driver of equity returns,
expectations of future real economic activity, and profits. First proposed by Fama (1981), the
argument is based on the money demand-quantity model, which predicts that an anticipated
future fall in activity lowers the demand for real money balances which, given an unchanged
stock of nominal money and interest rate, is accommodated by a rise in the price level
.
Extending this approach, Geske and Roll (1983) and Kaul (1987) suggest a role for
countercyclical monetary policy in which a negative output shock leads to lower equity
prices, easier monetary policy and, due to the rational agent expectations, a contemporaneous
increase in inflation
. Hasbrouck (1984) casts some doubt on these assumptions by failing to
find a relationship between expected inflation and expected output growth from survey data.
In a recent extension, Pilotte (2003) presents evidence which supports the conclusion that the
proxy effect reflects not just a negative correlation between expected output and inflation, but
a positive relationship between inflation and excess returns. Other work that posits a link
between inflationary expectations and real effects includes Evans and Wachtel (1993) and
Holland (1995). Spyrou (2004), however, found a positive relationship between inflation and
equities in emerging markets.

8
The most well-known example is first-in-first-out (FIFO) inventory valuation. In a period of high inflation,
accounting profits will be increased as a result of FIFO because the inventories produced further in the past are
recorded as being sold in the current period.
8
Equity risk premium

The “equity risk premium” hypothesis, was initially outlined by Malkiel (1979) and Pindyck
(1994). According to this model, as inflation variability increases, which it often does when
the level of inflation rises, the gross marginal return on capital will also experience increased
volatility. Assuming risk-averse investors, this should increase the required risk premium
from equities which would require an immediate decline in equity prices.


Long-run hedging

A number of studies have indicated that equities may indeed be an effective inflation hedge,
but only over very long horizons. Ely and Robinson (1997) find that stocks seem to maintain
their values relative to movements in overall price indices over the long horizons. Lothian
and McCarthy (2001), using long-run data for OECD countries conclude that equities are,
after all, a good inflation hedge, but that it takes “an exceedingly long time for this to
happen.” Ahmed and Cardinale (2005) conclude that equities have been an effective inflation
hedge in the U.S. for horizons of five years or more, although results for the UK and
Germany were mixed.

Another branch of the literature tests the Fisher hypothesis for equities using very long
sample periods. As Boudoukh and Richardson (1993) note, the hypothesis involves a
relationship between returns and expected inflation; the use of ex post inflation measures
introduces an error-in-variables problem. Using measures of ex-ante inflation, they present
evidence for a positive relationship between the nominal equity returns and both ex ante and
ex post inflation, particularly at longer horizons.9

A consensus has yet to be reached,
however. Engsted and Tanggaard (2002) conclude that U.S. equities have not proven to be an
effective long-run hedge against either expected or unexpected inflation. In contrast, Luintel
and Paudyal (2006) find that the majority of U.K. industry sectors have a long-run inflation
elasticity in excess of one.


Equities and monetary inflation
Danthine and Donaldson (1986) and Marshall (1992) argue that equities may provide an
effective hedge against inflation caused by monetary fluctuations, but not if it is caused by
real output volatility.
Graham (1996) also supports this view by noting that equity returns and
inflation were positively correlated during the 1976–1982 period in which, he argues, U.S.
inflation was driven by monetary factors rather than exogenous supply shocks.
What I take from the above (and the paper is 2009) is that the empirical evidence is mixed.

Saying that there is an underlying factor that affects equity returns (the volatility of real macroeconomic variables like GDP) does not mean that equities are good inflation hedges. Because you cannot easily separate out the 2 factors - inflation and underlying economic events.

Equities are surely better than nominal bonds (see FT piece - not the case in Germany). But they are not likely to be better than TIPS (ibonds) or Commercial Real Estate.

Commodities I am pretty agnostic on - not sure I believe the evidence that they are good inflation hedges. The period of high commodity prices also coincided with the great postwar inflation.

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Re: Stocks, Inflation, and the Strategic Implications

Post by not4me » Wed Oct 24, 2018 1:30 pm

bjr89 wrote:
Wed Oct 24, 2018 4:05 am
Sorry if I wasn't clear in what I was asking. Basically I'm just wondering why the risk parity community thinks stocks have an inverse relationship with inflation, when it's clear from both basic logic and historical examples such as hyperinflations that they in fact are positively related. Typical risk parity managers have equal parts risk exposure to stocks, bonds, and commodities. They believe that commodities are essential because both stocks and bonds respond negatively to inflation. I'm just wondering why stocks don't play the inflation hedging role of commodities, eliminating their need to own commodities altogether.
I underlined a phrase in the above quote -- this isn't clear to me & that may be my disconnect. There are better historians around that might see this & weigh in, but I'm thinking the 1970s might be a time to look at.

A slight shift in thinking though. As I said upthread, I think the recent years have not been a valid test of this type of strategy. I also wonder if going forward we'll see a difference from the past due to changes in the economy. Perhaps an illustration is best. Will a FAANG dominated market have similar characteristics to an economy where GM, Exxon, etc were the bigger fish? Is this a time when past performance will differ from future results?

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Re: Stocks, Inflation, and the Strategic Implications

Post by nisiprius » Wed Oct 24, 2018 4:16 pm

Here's what the relationship has been between annual inflation (horizontal axis), and the annual total return of large-company stocks (S&P 500 and predecessors) (vertical axis), 1926 through 2017, inclusive. Or, rather, here is the lack of any relationship.

The black line is the trend line.

The correlation coefficient is -0.006, virtually zero, confirming what we see visually in the scatter of the dots.

The green dashed line represents zero real return; points above it line represent years in which stocks beat inflation; points below it, years in which stocks fell short of inflation. The fact that most of the points are above the line show that stocks beat inflation in most years. The fact that the trend line is not sloped like the green line, and that the swarm of points do not show any tendency to be higher at the right end of the chart, shows that stocks do not track inflation. Neither do stock returns go in the opposite direction--the trend line is flat. (Of course, that means that real return is lower in years of higher inflation.)

The chart perfectly confirms Benjamin Graham's statement that "There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices."

It seems that the stock market just kept cranking out high but widely fluctuating returns year after year--independently of whether inflation is high or low. Most years it's been higher than inflation, but has had no tendency to get any extra inflation-beating kicker when inflation is high.

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Re: Stocks, Inflation, and the Strategic Implications

Post by siamond » Wed Oct 24, 2018 7:05 pm

nisiprius wrote:
Wed Oct 24, 2018 4:16 pm
Here's what the relationship has been between annual inflation (horizontal axis), and the annual total return of large-company stocks (S&P 500 and predecessors) (vertical axis), 1926 through 2017, inclusive. Or, rather, here is the lack of any relationship.
Because this type of analysis (which we see all too often in corresponding research) is about seeking an immediate linkage between the inflation in a given year and stock returns in the same year, and of course, there is none. What does it prove? Absolutely nothing. The effect of higher prices (of goods) on earnings and dividends obviously takes time, it's a feedback loop. Furthermore, as everything with stock returns, the short-term valuation vagaries (and corresponding economic spasms) are such that trying to isolate the fundamental signal is tricky.

We really should think a bit harder to a more proper backtest on this matter, something we can easily reproduce, as this topic keeps coming back... Personally, I am happy enough with the 'common sense' explanation of the (time-shifted) feedback loop, but obviously other people are harder to convince... In all these research links ValueThinker shared a few posts ago, there has to be some simple methodology ideas that can be easily reproduced.

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Re: Stocks, Inflation, and the Strategic Implications

Post by stlutz » Wed Oct 24, 2018 7:52 pm

But I think the question is more about changes in the rate of inflation rather than the absolute level of inflation.

So, inflation declining from, say, 12% to 5% would be considered "good" for stocks even though 5% inflation is still considered "high" in a mature economy.

To test that out I just did a correlation from 1960 to 2017 (just to focus on a more modern period). The relationship between returns and absolute inflation was -.11. The relationship between stock returns and the change in inflation from the prior year was -.27, which is somewhat more meaningful.

It's perhaps also useful to consider higher inflation and poor stock returns as both being the result of something else vs. as opposed to the former causing the later. The oil embargo situation has been brought up. But if you had no productivity growth for a decade or so (which also happened in the 70s), I would consider that to be bad for stocks. That fact also leads to higher inflation.

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Re: Stocks, Inflation, and the Strategic Implications

Post by rnitz » Wed Oct 24, 2018 8:32 pm

I think what may be missing is that the correlation of stock performance with inflation is not linear (with respect to the level of inflation). During small or moderate levels of inflation, stocks are a great inflation hedge. But at higher levels of inflation (when you really care about it) they are not. This graph from Dimson, Marsh, and Staunton over international markets captures this well. If you're counting on high equity exposure to give you safety under conditions of high, unexpected inflation you may be disappointed.

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Re: Stocks, Inflation, and the Strategic Implications

Post by nedsaid » Wed Oct 24, 2018 11:38 pm

bjr89 wrote:
Mon Oct 22, 2018 11:50 pm
Something I've struggled with lately is the general consensus among the macro / risk parity community that stock prices and inflation surprises have an inverse relationship.
Image
Of course, traditionally, stocks were viewed as inflation hedges (they can raise prices, they own tangible property, etc), but Bridgewater, AQR, and practically everyone else in macro risk factor world are notable for saying that equities decline with rising inflation and that one therefore needs commodity exposure in order to achieve balance. Maybe stocks get hurt because of the difficulty of managing a business in real terms during high inflation or rising discount rates. But something as simple as a quick google search into Wiemar Republic or the Venezuelan hyperinflations will teach you that their stock markets appreciated accordingly. Now I know here at the Bogleheads that commodities are viewed negatively from a strategic perspective and that I may be posing this question to the wrong community since I'm unlikely to get much disagreement... but what's with the disconnect here? To me, it sorta seems like stocks belong in the top two boxes and nominal bonds in the bottom two boxes, eliminating the need for things like commodities with zero real return. Perhaps Bridgewater has found some statistical inverse relationship in the short run, but isn't Venezuela evidence to the contrary? What do you guys think?
I think it would be accurate to say that it is inflation spikes that just kill stocks and are really hard on bonds too. We saw this with the 1973-74 stagflation scenario. Stocks can take gradually rising inflation as companies and their customers can adjust. The effects of an inflation spike take a long time to overcome, in the case of the 1970's stagflation, it took more than a decade.

What we are seeing is a market that is correcting, well, because it wants to. Interest rates jumped in early October and that spooked the markets. Talk of protectionism spooked the markets. Earnings have been strong. Hints out there that the Global economy might be slowing. But the news isn't that bad. Inflation has ticked up but it is still fairly low. Wage growth is pretty well behaved, no spikes there. But you know, there is always bad news out there. The markets just have chosen to focus on the bad news right now where a couple months ago that same bad news was ignored.

As far as commodity exposure, most often it is a drag on portfolio performance with the off chance they might hedge the stock market. They would have done well in the 1973-74 bear market but is all that drag worth insuring against a once in a lifetime event? So far, stagflation is not coming back.

The problem with all of this is that asset classes will perform as they will and not in accordance with our desires. In a crisis, who knows what crazy positions the hedge funds would have to unwind? One reason the performance of asset classes is not always predictable. The darned hedge funds are a gigantic black box, not sure what they are really doing. As in the past, we are pretty much stuck with riding out the volatility.

If you want to insure against inflation spikes, commodities seem to be the best option to counteract a falling stock market. The $64,000 question is if the premiums paid in performance drag most of the time are worth the cost of insuring against a very infrequent event. I don't have the answer for others but for myself I am just going to have to ride this out.

This is why I haven't given up on TIPS. So many Bogleheads gave up on them but to me seem a more viable option than commodities.
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Re: Stocks, Inflation, and the Strategic Implications

Post by typical.investor » Thu Oct 25, 2018 1:07 am

While very interested in the topic, I doubt whether the 70’s are that relevant to today.

Of course stocks suffered then as correct me if I am wrong, but wages generally kept up with inflation didn’t they.

With the tendency to and ease of offshoring so much today, I suspect people would lose their jobs in cases where that’s possible. Then, those unemployed will compete for jobs that can’t be moved.

Of course there are limits, but we can see today with low unemployment there is little wage pressure. An effect of internationalization I suspect.

It doesn’t mean I am writing off inflation because who knows if the current system will remain intact or we’ll see a split in systems (US centric vs Chinese centric).

Or ecological collapse.

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Re: Stocks, Inflation, and the Strategic Implications

Post by not4me » Thu Oct 25, 2018 6:41 am

typical.investor wrote:
Thu Oct 25, 2018 1:07 am
While very interested in the topic, I doubt whether the 70’s are that relevant to today.

Of course stocks suffered then as correct me if I am wrong, but wages generally kept up with inflation didn’t they.
This touches on really several parts. 1st, I was hearing OP suggest that commodities were redundant with stocks in regard to reacting to "inflation". As I said upthread, there are different forms of inflation. Your recollection may be right (I'm not really sure) & so perhaps the main driver for that time was "wage inflation". Regardless, I resorted to some crude web searches & it looks to me that in 1974 GSCI returned ~+40% while SP500 was -30% & CPI ~+11.

Another point is whether it is relevant today. I likely share your doubts, but don't know how far in advance it was telegraphed in 1974 either. I doubt my house will burn down today, but I still carry insurance. Which gets to following point:

nedsaid wrote:
Wed Oct 24, 2018 11:38 pm

The $64,000 question is if the premiums paid in performance drag most of the time are worth the cost of insuring against a very infrequent event. I don't have the answer for others but for myself I am just going to have to ride this out.

This is why I haven't given up on TIPS. So many Bogleheads gave up on them but to me seem a more viable option than commodities.
The more cost effective insurance in 1974 may not be same product today. Personally, I may not need as much today as I did then; which may be less than someone else. TIPS weren't available in 1974 as an alternative. As I raised earlier, I wonder whether the shift in the makeup of big players in sp500 will change the frequency in which commodities do provide insurance

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Re: Stocks, Inflation, and the Strategic Implications

Post by nedsaid » Thu Oct 25, 2018 1:32 pm

The problem with trying to design an all-weather portfolio is that the future is unknown. History doesn't exactly repeat but it does rhyme. So we know bear markets are in the future but each time the circumstances are different and each time the cause is different. The oil shocks in 1973-1974 were called shocks in part because we didn't know in advance they were coming. Just as most all of us didn't see the subprime crisis come up in 2008-2009. Bad events take us by surprise. So we design our portfolios around avoiding the bear markets of the past. But it is the old fighting the last war problem. Since we don't know what will cause the next bear market, that makes it hard to prepare against.
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Re: Stocks, Inflation, and the Strategic Implications

Post by Valuethinker » Thu Oct 25, 2018 5:03 pm

stlutz wrote:
Wed Oct 24, 2018 7:52 pm
But I think the question is more about changes in the rate of inflation rather than the absolute level of inflation.

So, inflation declining from, say, 12% to 5% would be considered "good" for stocks even though 5% inflation is still considered "high" in a mature economy.

To test that out I just did a correlation from 1960 to 2017 (just to focus on a more modern period). The relationship between returns and absolute inflation was -.11. The relationship between stock returns and the change in inflation from the prior year was -.27, which is somewhat more meaningful.

It's perhaps also useful to consider higher inflation and poor stock returns as both being the result of something else vs. as opposed to the former causing the later. The oil embargo situation has been brought up. But if you had no productivity growth for a decade or so (which also happened in the 70s), I would consider that to be bad for stocks. That fact also leads to higher inflation.
Actually US gdp grew more in real terms in the 1970s than the 1980s.

And productivity continued to grow. There was an abrupt slowdown from the 1946 to 1972 average, but then it has never been regained *except* for a period at the end of the 1990s.

The 1979 1980 oil shock was worse than the 1973 one. So what went wrong in the 1970s was not just about oil.

Rising inflation and rising real interest rates seem to be bad for stocks and falling good for stocks. On the 1968 to 2000 evidence at least.

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