Mark Hulbert: Equity Investors Don’t Understand Inflation

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.

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  1. esb

    “This idea did not cross the mind of the economists, however.”

    This is why I harbor the highest contempt for the “community of university-based economists” in the USA, and most particularly for Mark Gertler (and his best bud Benjamin S. Bernanke), who is eerily comfortable with the use of inflation as a tool of choice.

  2. Jojo

    Watch this video to see how the government across many administrations has manipulated GDP & Inflation numbers. Many of us already know about this manipulation but this author does a very good job of illustrating how and why it is done:

    Fuzzy numbers

    Of course, it is advantageous for governments to try to make economic numbers appear rosier than they are. As always, the question is how to keep them honest and exert some control over how the numbers are constituted? After all, how can anyone make effective economic decisions when the data used to do so has been heavily manipulated?

  3. Independent Accountant

    I have said these things for decades. Over the long pull, inflation should not hurt stocks. You can use inflation to help you pick stocks. Pick stocks with a lot of fixed-rate debt in their capital structure. It’s bonds that inflation will kill. Got gold? Get more. Study the experience of stock and bond owners during the 1922-23 German hyperinflation.

  4. S

    Havn’t read the article, but the whole inflation = good for stocks, simply look at the market in the 70s. Relative performance doesn;t help you at the grocery store either. Agree on got gold…

  5. Dave

    “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”

    Well, this is a bet you would lose, give the CFA Institute’s fetish for inventory accounting and the differences between FIFO and LIFO costing.

    You probably are right, though, that most people under 35 have not worked in an inflationary environment. But at least some people who work in finance have been forced to think about FIFO vs LIFO.

  6. Clayton

    Yves… aside from unveiled derision, what exactly is your position on this?

    Are you arguing that it’s counterfactual? Or are you trying to argue that the theory is unsound?

    I ask because the foundation for his argument is actually quite old (i think it was a ’56 paper I saw) and economically sound… I could find and cite the original paper if you like.

    If you’re saying that his argument is counterfactual, then I’d press you to explain if you think the mechanism he suggests is inaccurate… or if you’re saying that there are offseting inflationary pressures that cause the counterfactual reality (and would encourage you to identify these factors).

  7. Sivaram Velauthapillai


    I think your argument, whether true or not, has little to do with the point that Mark Hulbert is making. I think you guys & gals are touching on different issues.

    You seem to be looking at inflationary impact on the business. Whereas, the article is talking about the impact on investment.

    Most of what you say harkens to the difficulty faced by managers of the business. Ok, so the accounting is confusing and hard to decipher with fluctuating inflation. But that’s not exactly what investors are looking at.

    Investors, on the other hand, care about long term profits. If, as Hulbert points out, long term real profits stay the same, then investors should find stocks attractive.

    I suspect the reason investors chop down stocks during inflationary periods is not because of inflation per se. Rather, I suspect they project ever rising inflation far into the future. This is similar to how we had a technology/growth bubble because investors projected high growth rates far into the future. As mentioned in the article, Mogdiliani’s point that stocks were cheap in the late 1970’s was true. But the market clearly didn’t agree. The reason is likely because it was projecting ever increasing inflation far into the future. Not for the next year or two but for the next t0 years.

    So to sum up, most of what you are saying may be true. However, they deal with the difficulties faced by managers of business and not investors. The approaches are not the same and the two parties will not necessarily look at a share in a business the same way. (To see what I mean, consider China and India which have had nominal inflations of 5% to 8% over the last 5 years. Accounting would vary but, nevertheless, business managers in those countries would have faced the problems you cited. However, investors have been tripping over themselves for the stocks.)

  8. Yves Smith


    To deal with your argument in reverse order, the reason investors are so keen to buy stocks in China is they have no reasonable alternatives as far as where to put their money. At conferences on China, they have discussed this conundrum at some length. Bank accounts yield under 1% in an economy where reported inflation is, as you point out, between 5% and 8%, there is pretty much no public bond market, and real inflation is probably higher. One comment by an economist: "if you wanted to create a system that would produce hyperinflation, you couldn't do a better job."

    As for equities, I am surprised at the lack of consideration of what an stock really is. Equities are a very ambiguous promise. Maybe you get dividends if earnings are there and management decides to pay them out. You can be diluted. Your principal return depends on the whims of other investors. You may get lucky and management may goose the price with a buyback, but (as banks have found recently), ill-timed buybacks can leave investors worse off than doing nothing.

    Historically, such an ambiguous promise was never traded on an arm's length, anonymous basis. The only relationship that made sense was a venture capital/private equity type relationship, where the investor knew or could get to know the principals personally, and make a thorough examination of the company's financials, operations, and strategy, and would also be able to get detailed updates.

    The compensation mechanism for the lack of this sort of relationship and insight has been detailed financial disclosure. However, as Columbia professor Amar Bhide pointed out in an Harvard Business Review article, "Efficient Markets, Deficient Governance" that that disclosure is in fact inadequate (and note that Bhide was a former proprietary trader at a Wall Street firm and continues to be a successful investor).

    Public companies simply cannot make the sort of disclosures about their strategies and prospects that investors require because they would give too much away to competitors.

    So equities are already "trust me" paper, and have an element of risk that investors have come to accept (and for many investors, perhaps to ignore). This is why Warren Buffet and others stress the importance of management. It isn't just their competence, it's also having faith that they really are doing the right thing in the absence of the investor's ability to make that assessment before it is too late.

    Now throw inflation into the mix. Those financials, the investor's one good means of evaluating a company, suddenly fall into question, and it is because inflation is not "pure" inflation, with all line items inflating at the same rate. The variable impact of inflation makes financial statements, and particularly margins, questionable. Any kind of historical comparisons and trend line analysis becomes dubious.

    Capital intensive companies are certain to be overpaying taxes in a real sense due to the erosion in value of their depreciation shield. This is a real cost, not a computation error.

    Similarly, companies that are require a high level of ongoing investment (in R&D, in advertising) tend to scrimp because so few projects pass muster when high discount rates are applied. Again, the investor suspects they are trying to preserve current profits at the expense of future earnings and competitiveness, but has no way of knowing to what degree.

    Third is the delta in inflation. Inflation is seldom static. In the 1970s, inflation in most economies tended to pick up steam until central banks intervened aggressively. The cost, as anyone who lived through it can attest, was a very nasty recession that was even more punitive to financial assets than the inflation that preceded. And there were considerable doubts that the remedy was working while it was being administered.

    The reason that the Great Moderation has been so widely praised in economic circles is that more stable growth (ie less deep recessions) and stable and not too high investment rates lead to greater willingness of businesses to expand and invest (this point is debatable, in my mind, since growth was higher in the 1950s and 1960, but inflation was also lower then, which may have been a bigger driver than the dampening of economic cycles. I personally think that the whatever virtues of having stable growth have been offset by the pronounced behavioral change that started in the 1990s of management of public companies becoming fixated on meeting short term earnings targets. This has led them to underinvest, as many buddies in public companies and their advisers tell me, just as inflation would. But investors have also become very short-term oriented. The holding period of the average NYSE stock is under a year).

    But the general point is that inflation over a modest level introduces real, ADDITIONAL uncertainties into the valuation of stocks. Greater uncertainty means greater risk, greater risk means investors demand higher returns, Higher returns mean higher REAL discount rates, which leads to lower stock prices for the same dollar of earnings.

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