The Investment Scientist

Inflation and Stock Return

Posted on: May 20, 2021

Since I started investment management fifteen years ago, I can’t recall a time when the risk of inflation is as pronounced as it is today. Since the onset of the pandemic, the Fed has created $5 trillion worth of money. Now, as the economy is reopening, the torrent of money is gushing into circulation, lifting inflation to 4.16% in April alone and possibly higher down the road. How the market behaves is our study today. 

I asked Taro to look up Bob Shiller’s dataset and Kenneth French’s dataset and run a correlation analysis of stock returns vs inflation. Here is the result in a chart along with my observations. 

The chart here is the scatter plot of the S&P 500 returns relative to annual inflation. Please pause and think about what inference you can draw from this chart before moving on to the next paragraph.

As one can see, there is a slight negative correlation. That is to say, as inflation becomes higher, one should expect stock returns to moderate. Since the current inflation is 4.16%, pay attention to the [2.50%, 5.00%] interval, the distribution of returns is not substantially different from the [0.00%, 2.50%] interval that we were in during the last ten years. Financial pundits want you to believe that the correlation between inflation and bad return is straightforward and deterministic, it is anything but. 

It is only when the inflation rate is over 7.5% that the odds of loss dominate the odds of gain. Surely, inflation bears watching carefully, however, there is no reason to panic.

If you are a client of mine, and you have concerns (or insights) about inflation, let’s talk. Feel free to schedule a time with me here: HTTP://calendly.com/mzhuang/30min.

Schedule a 2nd opinion financial review, buy my wealth mgmt book on Amazon.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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