Author Topic: Inflation, Index Funds and their Relationship  (Read 5288 times)

Scubatoad

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Inflation, Index Funds and their Relationship
« on: May 08, 2014, 06:58:30 AM »
I have been looking for some articles on this exact topic, and I cannot seem to find many. 

My basic question is:  Has inflation played a significant role on the stock market's climb over the last 100 years?

Is the stock market generally considered a hedge against inflation?

I was in google images typing in "inflation compared with stock index" and looking through the graphs and it looks like the do share some similiar patterns.

Not sure if this is a really basic concepts where everyone on the forums will shake their head and say...DUH!...but I am no expert and just trying to wrap my head around these concepts.

aclarridge

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Re: Inflation, Index Funds and their Relationship
« Reply #1 on: May 08, 2014, 07:18:41 AM »
I don't have any data, but my impression is that they're a long term inflation hedge. Like if you look at a decade that had pretty high inflation, the stock market should generally do pretty well during that time (probably there are some cases proving me wrong but I think that just means the 10 year time window isn't long enough). In most industries companies just raise prices when inflation forces them to, and therefore their revenues correlate fairly well with it. Inflationary times are difficult economically though so I would also expect that the real return of stocks is lower during inflationary periods in general.

Short-term though, it's too volatile to correlate well with anything.

arebelspy

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Re: Inflation, Index Funds and their Relationship
« Reply #2 on: May 08, 2014, 07:24:42 AM »
I don't have any data, but my impression is that they're a long term inflation hedge.
...
Short-term though, it's too volatile to correlate well with anything.

This.

If you think about what inflation is (in very simple terms, the price of goods going up) and what index funds are (in very simple terms, a small part ownership of all the businesses), you'll see that it has to match inflation (those goods that cost more... who is selling them? the businesses you own, which = more profits which = worth more = higher index fund price), or beat it if the companies/economy is growing.
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hodedofome

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Re: Inflation, Index Funds and their Relationship
« Reply #3 on: May 08, 2014, 08:03:52 AM »
Look at the 1970s. High inflation and the stock market was down (stagflation).

I always cringe when taking past correlations between some fundamental economic measure and stock prices, and extrapolating that into the infinite future. IMO anything can happen, including a future where inflation continues to go up and the stock market continues to go down.

arebelspy

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Re: Inflation, Index Funds and their Relationship
« Reply #4 on: May 08, 2014, 08:12:19 AM »
IMO anything can happen, including a future where inflation continues to go up and the stock market continues to go down.

Short term, absolutely.  Your 1970s example was a perfect one.

Long term?  If the country is ending, perhaps.  Constant shrinking. But that's a localized thing.  Own some international stocks.

I can't see constant inflation yet the businesses selling those goods being worth less over a long period of time, barring catastrophic world failure.  But maybe I'm missing something, and someone can explain a scenario where that could happen.
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warfreak2

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Re: Inflation, Index Funds and their Relationship
« Reply #5 on: May 08, 2014, 08:19:47 AM »
If you think about what inflation is (in very simple terms, the price of goods going up) and what index funds are (in very simple terms, a small part ownership of all the businesses), you'll see that it has to match inflation (those goods that cost more... who is selling them? the businesses you own, which = more profits which = worth more = higher index fund price), or beat it if the companies/economy is growing.

Too much inflation is bad for business, and I doubt the stock market wouldn't match inflation in the long term if high levels of inflation (say, 10%+) were the norm. I wouldn't call stocks an inflation hedge, because inflation can very well destroy the value of the companies you own shares in.

Stocks are a good way to share in the prosperity of the economy, because a good proportion of companies you're invested in are providing for people's wants, rather than their needs - and when people are doing well, they meet all their needs and also spend a bunch of their wants. However, when people can't afford their wants because their wages are lagging behind inflation, your stock index funds will do poorly. To hedge against inflation, invest in needs - housing, for example.

hodedofome

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Re: Inflation, Index Funds and their Relationship
« Reply #6 on: May 08, 2014, 08:31:12 AM »
This is the reason Harry Browne started the most loved/hated strategy on the internet - the permanent portfolio. It was the 1970s that woke people up to the idea that stocks weren't always an inflation hedge. Divide your assets equally between the 4 possible future scenarios:

high inflation - gold
high growth - stocks
low/neg growth - treasury bonds
deflation - cash

I think of Harry Browne as a Jack Bogle who is more worried about the future. Although your returns won't be as good as a 60/40 stock/bond portfolio in a normal market, in a bad environment the perm portfolio will have a better chance of survival.

arebelspy

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Re: Inflation, Index Funds and their Relationship
« Reply #7 on: May 08, 2014, 08:54:57 AM »
This is the reason Harry Browne started the most loved/hated strategy on the internet - the permanent portfolio. It was the 1970s that woke people up to the idea that stocks weren't always an inflation hedge. Divide your assets equally between the 4 possible future scenarios:

high inflation - gold
high growth - stocks
low/neg growth - treasury bonds
deflation - cash

I think of Harry Browne as a Jack Bogle who is more worried about the future. Although your returns won't be as good as a 60/40 stock/bond portfolio in a normal market, in a bad environment the perm portfolio will have a better chance of survival.

I prefer real estate instead of gold for an inflation hedge, but yes, your point is well taken.

The PP is a much more conservative portfolio.  I don't expect it to grow much, and so I think it's pretty terrible for those striving for ER, and just okay for those already ER'd (it will require a much lower SWR, thus longer working time), but for those that are fearful, it's a good peace of mind portfolio.
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hodedofome

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Re: Inflation, Index Funds and their Relationship
« Reply #8 on: May 08, 2014, 08:59:26 AM »
Sure, if you can learn how to landlord well, having your inflation hedge actually provide income is a much better option than gold which just sits there. Though you've got to really dive in there and learn how to do it well and not lose your shirt.

schimt

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Re: Inflation, Index Funds and their Relationship
« Reply #9 on: May 08, 2014, 11:27:23 AM »
Sure, if you can learn how to landlord well, having your inflation hedge actually provide income is a much better option than gold which just sits there. Though you've got to really dive in there and learn how to do it well and not lose your shirt.

He may have also been refering to something along the lines of REIT's, which are a passive and diversified option for real estate investing

arebelspy

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Re: Inflation, Index Funds and their Relationship
« Reply #10 on: May 08, 2014, 11:48:10 AM »
Sure, if you can learn how to landlord well, having your inflation hedge actually provide income is a much better option than gold which just sits there. Though you've got to really dive in there and learn how to do it well and not lose your shirt.

He may have also been refering to something along the lines of REIT's, which are a passive and diversified option for real estate investing

I personally probably wouldn't swap gold for REITs 100% 1-to-1 in a PP (though I may consider doing so partly), but REITs are a decent inflation hedge in a more traditional portfolio.

YMMV, of course.
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innerscorecard

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Re: Inflation, Index Funds and their Relationship
« Reply #11 on: May 15, 2014, 08:08:09 PM »
Just a random thought I had. Isn't selling LEAP puts and/or buying LEAP calls an inflation hedge as well?

milesdividendmd

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Re: Inflation, Index Funds and their Relationship
« Reply #12 on: May 15, 2014, 11:41:57 PM »
To answer your question, stock prices to tend to rise with inflation. But inflation is not the major driver of returns in the stock market. The major drivers for capital appreciation, and dividend growth.

Put simply: the US stock market has had a real return of greater than 7% over the past 100 years. And by definition "real return" is the increased value of stock and dividends after subtracting value lost to inflation.

A more anecdotal argument against inflation being a major driver is the massive growth of the stock market over the past several years at a time of historically low inflation.

Alexi

Scubatoad

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Re: Inflation, Index Funds and their Relationship
« Reply #13 on: May 27, 2014, 05:57:26 AM »

dmn

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Re: Inflation, Index Funds and their Relationship
« Reply #14 on: May 28, 2014, 01:41:16 AM »
Just a random thought I had. Isn't selling LEAP puts and/or buying LEAP calls an inflation hedge as well?
Instead of selling puts and buying calls, you can just as well buy the underlying stocks / index funds. What is the benefit of synthesizing stocks through an added layer of derivatives?