Inflation and the Stock market

 Are common stocks really a Good hedge against inflation? This question, often asked by Investors, is less likely to puzzle. The Historical market return tells us that, in the long run, common stocks are a good hedge against inflation but poor for a short-term. 

For example, Nifty”s average return is 14 percent CAGR, including dividend. India”s average inflation Rate is 5 percent if so, real return is 9 percent, ( Actual return - inflation= real return)

Inflation erodes currency and reduces purchasing power that”s why we could not purchase same volume goods with same money because of inflation. So the return rate should be calculated after subtracting the inflation rate.   

The stock market hates inflation that would lower stock prices. The current stock prices are determined by two factors:  future interest rates and future dividends; higher inflation leads to higher interest rates. For Example, if you approach your neighbor to borrow 1 lakh rupees, who agrees to pay loan with 7 percent interest for a year. Because, who wants to retain their money value  with the same purchasing power and with a profit. Banking and Financial institutions are no different, they would impose higher interest rates if they consider future inflation will be Higher. 

Inflation affects profit margin

Inflation affects prices, and so all economic transactions are dependent on future prices. During the period of accelerating inflation, while the Businesses and individuals can not make their investment decisions and budgeting money for the future  because unstable inflation creates fear amongst investors, they don't know how interest rates will change in the future. 

•  Business entities purchase inventory for future production and sale, 

• plants and equipment are built for future use. 

•  money is borrowed to be spent in the future and to be repaid out of revenue.

 Increasing inflation rates cause uncertainty, unstable inflation results in poor inventory policy, lags in production, confusion in capital expenditure, and severely affects business planning. For this reason sales will fall, then production, then earnings and corporations will not be unable to pay adequate dividends to shareholders. The key elements of stock valuation is expected future flow of Dividends and Earnings.

Inflation hit the stock market

Increasing interest rates are bearish for the stock market. The rate of inflation and rate of interest are closely tied to the rate of stock return. Because alternative interest bearing securities  like Bonds could provide attractive returns to offset accelerating inflation rate. Which is less risky compared to common stocks. Equities must offer higher returns than any other asset classes. 

The best way to obtain a higher return in any investment is to pay a lower price for it and so common stocks  fall in price until they reach intrinsic value that match with future earnings and future dividends.

A constant  inflation rate is bullish for the stock market and also businesses can easily allocate their financial resources even if it is higher. In addition, businesses are able to adjust their production and pricing schedule to provide a positive net real return. Both conditions are bullish for the stock market.

Short and Long run 

In the long run interest and inflation approach a middle norm making common stocks attractive relative to other investment options. During periods of accelerating inflation, common stocks therefore make poor investment and should be sold. In The long run, common stocks are an excellent hedge against inflation.

Evaluate Equity  valuation

The current stock prices are measured by forecasting numbers. Generally, stocks are priced in, in a expectation basis, Future earnings, Future dividends, and future cash flow are key tools to evaluate equity”s intrinsic value. 

Dividend discount Model represents the future dividends 

Discount cash flow model which find out Net present value of stocks through future cash flow 

Forward PE ratio shows earnings of the future. 

Use theses metrics wisely then take your investment decisions.