An article in today’s New York Times, “Illusions About Inflation,” by Mark Hulbert is based on the sort of research that gives economists a bad name.
The piece references an a academic paper “Inflation Illusions and Stock Prices,” by John Campbell and Tuomo Vuolteenaho, that argues that investors analyze stocks incorrectly during inflationary times because corporations can pass cost increases on and show higher earnings growth. I’d shred this paper in more detail, except I’m unwilling to spend $5 to buy it, so I’ll go on Hulbert’s summary and the abstract and just give the high concept.
High inflation introduces uncertainty of two sorts. First, financial statements become unreliable, since inflation is not consistent and various line items inflate at different rates. Anyone who contended with inflation accounting in the late 1970s will tell you how painful and unsatisfying it was. Vastly more time was spent trying to produce financial statements that were consistent (in real terms) over time, and all the participants knew quite a few highly debatable assumptions went into the recasting, so no one regarded the supposedly better reworked version with much confidence. For instance, the choice of LIFO versus FIFO was very important (I am willing to bet that no one under 35, unless they have invested or worked in a high inflation economy, has given much thought to LIFO versus FIFO). Another worry is that depreciation is too low (it’s based on historical prices) which leads to overstated earnings and worse, an inadequate depreciation tax shield (the business is thus overpaying taxes).
Second, businesses tend to underinvest because they discount future projects at high discount rates. And since inflation rates are not static, companies and investors tend to set a conservative (ie, at least as high as the current) inflation rate to guard against understimating future inflation. Companies that underinvest are at risk competitively (loss of product quality, need to catch up later on capital improvements, etc.). Investors will suspect companies are underinvesting but not know to what degree.
These uncertainties lead investors to demand higher REAL returns in inflationary times, which would legitimately lead to lower prices even if companies can pass along cost increases. This idea did not cross the mind of the economists, however.