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In a healthy economy, prices tend to go up, also known as inflation.

While you might not like that as a consumer, moderate price growth is a sign of a healthy, growing economy.

However, when this happens, the general notion is that people earn less in real terms i.e. after adjusting for inflation. This results in lower returns from their investments, net of inflation.

Second, higher inflation could lead to higher interest rates. This could impact the cost of capital for investors.

Co-head of research at Equitymaster, Rahul Shah recently did a study between inflation and stock market returns to dive deeper into some of these concerns.

We reached out to him to discuss his findings and more. Here’s what he had to say.

#1 Tell us about why you chose to do this study between inflation and stock market returns?

After being benign for quite some time, inflation seems to be rearing its head again.

The Commodity Price Index or the CPI as it’s popularly known, spiked to 6.3% in May from 4.2% in April.

That’s a huge jump. The worst part is that the index has remained at these levels in June as well, the second month in a row.

Now, if inflation doesn’t come under control and remains at elevated levels, it can raise the cost of living for a common man.

It can make day-to-day items expensive, thus forcing him to dip into his savings or cut down on his expenses or both.

Historically, the stock markets have proven to be excellent protection against inflation.

Their annual average returns of 14%-15% have been more than enough to beat inflation and also grow one’s wealth at a steady pace.

Thus, it looks like a settled case that if you have to beat inflation, equities are the place to be. It’s as if they have built-in protection against inflation.

Well, not so fast!

My study of the relation between inflation and stock market returns resulted in some interesting findings.

You see, investors tend to extrapolate a 20-year performance over a shorter duration of 3 to 5 years. They automatically assume that if stocks have given a 14%-15% CAGR over the long term, they are certain to do so over a 3 to 5 year period as well.

Nothing could be further from the truth. To be honest, a lot of us do not make our investment decisions based on how stocks will do over a lifetime of investment.

We take a 3-year or a 5-year approach to investment and decide on our next moves based on how we have performed over this shorter duration.

And it’s here where it gets tricky.

My study showed me that there is often no correlation between high inflation and stock market returns over a 5 year period.

Besides, stocks have not always rewarded investors with inflation-beating returns even over a period as long as 5 years.

I believe that the takeaways from my study have important implications for how one should go about investing in stocks, especially from a 3 to 5-year perspective.

#2 What were your key findings? Do they confirm the general beliefs people have?

My modus operandi was simple. I divided the 20-year period between 2001 and 2020 into four blocks of five years each.

I then analysed the relationship between inflation (CPI) and the Sensex returns during each of these 5-year blocks.

Here are the results in the form of a table

Source: inflation.eu, ACE Equity
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Source: inflation.eu, ACE Equity

First things first.

A period of low inflation does not necessarily mean low returns from the stock market.

The period between 2001 and 2005 is proof of this. The inflation was the lowest in this five-year period and yet, the Sensex had its best-ever five-year returns.

Likewise, high inflation rates i.e. the ones prevailing between 2011 and 2015, does not mean high stock market returns.

In fact, it will be wise to conclude that over a 5-year period, the returns are more a function of the stock market valuation than underlying inflation.

Whenever the Sensex PE has been attractive and in the range of 17x-20x, Sensex has gone on to give good returns over the next five-year period.

And when it was expensive at 22.4x at the start of the year 2011, the returns over the next five years have been poor.

In fact, here the Sensex was not even able to beat the rate of inflation.

#3 What is the key takeaway for investors who are looking at inflation and making investment decisions?

Of course, this is not a big enough sample size to come to any definite conclusion about the relation between inflation and stock market returns. However, the logic is hard to refute.

Since inflation is hard to predict and since we are a growing economy, it makes sense to invest in stocks to beat inflation.

However, one also needs to consider the broader stock market valuation before making a huge commitment.

If the valuation looks high by historical standards, it may not be a bad idea to invest say only 50% in stocks and then wait for the stock markets to correct before putting the entire 100%.

This may be an important point to consider since one’s probability of earning good returns from stocks is much better when investments are made at attractive valuations.

There is a risk of earning sub-par returns, especially over a 3-5 year period if a lot of exposure is taken at high valuations. The period between 2011-2015 is a case in point.

#4 By the way, congrats on your 22-stock winning streak for Exponential Profits. How are you positioned for the future?

Thank you.

I strongly believe that the key to figuring out the game of investing is not whether to buy large caps or midcaps or buy value or growth or even cyclical or secular stocks.

The key is to figure out first and foremost whether to play offence or defence.

The time to play offence was back in March 2020 when the coronavirus pandemic had crashed the stock market and the following 3-6 months.

But with the stock market having gone up significantly since then, it is perhaps time to tone down offence a bit and turn more defensive.

And this is exactly what I have been doing with Exponential Profits.

However, this doesn’t mean I have gone entirely into cash or bonds. I still have a good exposure to stocks but it is not as high as what we had the same time last year.

This is how I would like it to be unless there’s another significant correction in the market.

#5 Please share with our readers 3 stock pickers you admire the most, and why.

Well, the three stock pickers I admire the most would be Ben Graham, Warren Buffett, and Walter Schloss.

The first one for writing arguably the best book on investing out there i.e. The Intelligent Investor.

The second one for taking the learnings of Ben Graham and extending it beautifully and turning it into a totally new and immensely profitable branch of investing.

And last but not the least, Walter Schloss, for achieving what he has achieved in the simplest manner possible and without any access to management ever or any sophisticated investment techniques.

As you can see, one need not worry about inflation as much when it comes to investing in equities.

However, you can change your overall investing strategy based on periods of high and low inflation.

If you want to make consistent long-term profits in the market, you need to know the best way to tackle these periods.

One must also note that while an obscenely high inflation can play havoc with purchasing power, a certain threshold of inflation is required to incentivize producers and businesses.

Inflation beyond an acceptable limit is the real problem but overall, it’s essential for growth.

It’s this balance that holds the macroeconomic key.

(This article is syndicated from Equitymaster.com)

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