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So how does inflation affect the market? Well, it’s not good. Inflation is a tax on capital. It’s a way for the government to get your money without asking. In fact, the only thing worse than inflation is deflation.

I took 80 years of monthly stock market return and ranked them by inflation (lowest to highest). Then I wanted to see the cumulative return as the rate of inflation increased. Here are the results.

At the far left are the most deflationary months, and the far right are the most inflationary. The blue line shows the after-inflation cumulative return of the market.

As you can see, deflation has a negative impact on equity prices. The market falls until about the 70th data point which corresponds with an annualized deflation rate of 5.5%. The vast majority of those months were in the 1930s.

Stocks rise very steadily until it hits a brick wall around data point 660. That corresponds with an inflation rate of 5.1%.

Posted by edelfenbein at December 14, 2007 10:26 AM