Ignore the Inflation-Adjustment Scoundrels

Adjusting stock indexes for inflation is a waste of time because corporate earnings, which drive share prices and indexes, already reflect inflation.

Um, it already reflects inflation.

Photographer: Bryan Thomas/Getty Images

The last refuge of scoundrels is their blind insistence that all data points must be adjusted for inflation.

I was reminded of this earlier in the week when Nasdaq, after 15 long years, closed above the 5,000 mark. The immediate response from parts of the bearish contingency was to demand that the numbers take into account the rise in prices.

There are many, many reasons why this is irrelevant to investors.  Let’s focus on just three:

The first is technicals. When practitioners of this form of analysis look at support and resistance lines in a graph of a stock or index, they are actually delving into the world of psychology. Traders recall that when they bought stocks at a specific price, they were rewarded. That muscle memory keeps them coming back for more at those prices. This is true for stocks, exchange-traded funds and even indexes.

Similarly, they remember being punished when they paid too much at specific prices. Who among hasn't thought to ourselves, “Dear Lord, let me just get back to break-even”? That is why share supply often appears at specific prices. It is a sign of investors recalling an earlier purchase that has been painful.

This gross oversimplification of technical analysis is why inflation is irrelevant to index prices. Regardless of your views of markets as efficient or investors as irrational, no one inflation-adjusts their positions in their heads.

The second is retirement savings. Investing in equities is an effort to preserve purchasing power. It isn't that investors don’t understand that inflation erodes the value of their dollars; rather that is the entire point of investing -- to get ahead of inflation. Given that the average long-term return of U.S. equities is about 10 percent, and the average rate of inflation is about 3 percent, that has worked our pretty well during the past century.  

Third, and perhaps most important, is how the fundamental valuations of equities are calculated. These ratios compare a stock’s price with some significant basic metric of its business. There are many options to select from, be it discounted cash flow or trailing earnings or dividend yield or revenue. Regardless, you are always calculating a number that is the ratio of two numbers, i.e., a fraction. The numerator is usually the share price, and the denominator is whatever other data point you choose.

To determine an inflation-adjusted valuation, you would have to discount both the price AND the earnings (or whatever other element that is your preferred basis of fundamental measure) for the inflation rate. Multiplying the top and bottom of a fraction by the same number doesn't alter the ratio. Thanks for a whole lot of nothing.

Understand that I am not saying inflation isn't a meaningful issue. It is a pernicious threat to holders of any asset -- cash, stocks, commodities, real estate and especially bonds.

But of all of these, stocks tend to be a good inflation hedge, because earnings are the main driver of share prices. When we look at what goes into a company’s revenue and profit, it is clear that inflation affects all of the above.

Producer prices and other inputs are sensitive to inflation. When those rise, companies' costs increase. Prices for labor, finished goods, raw materials, rent and transportation all rise in response to broad inflationary pressures. It is an ongoing battle for companies to keep their input costs as low as possible. A company’s total profits are going to be significantly discounted by its higher overall costs of producing any product or service. Hence, their earnings are already inflation-adjusted -- they are lower due to the increased costs inflation has imposed.

Companies have choices when their costs of production rise. They can pass along input cost increases to their clients. They can pressure suppliers to hold down prices. They can accept reduced margins in order to preserve market share. But those are all decisions made by the managers.

Some businesses have pricing power. They can charge more, and increase their revenue -- assuming their competitors do the same. This, of course, won't work if their customers have less expensive alternatives.

All of which brings me back to the issue of inflation-adjusting stock prices. It misses the main point, which is to expand a business faster than the rate of inflation.

When earnings AND stock prices both rise together, adjusting for inflation tells us precisely zero about valuations. 

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