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With today’s report showing how steeply prices fell last month, I wanted to revisit the issue of inflation’s impact on stock prices. Let me add the important caveat that correlation doesn’t necessarily mean causation. The short answer is that inflation is bad for stocks. In fact, the only thing worse is deflation. What the market likes is inflation that's nice, steady, predictable and low.

Going back to 1926, there have been 72 months of deflation coming in below -5%. The inflation-adjusted total return for that period is an annualized loss of -9.6%.

Here's how it breaks out.

Inflation Rate............Real Stock Returns (annualized)
Below -5%..............................-9.6%
Between 0% and -5%.............20.9%
No Inflation.............................17.1%
Between 0% and 2%..............10.0%
Between 2% and 5%..............14.1%
Between 5% and 7.5%...........-0.2%
Between 7.5% and 10%.........-2.8%
Over 10%...............................-11.1

Basically, when inflation is over 5% or under -5%, the market averages a real 5.5% loss. When inflation is between -5% and 5%, it average a 15% gain.

Posted by edelfenbein at November 19, 2008 1:48 PM