Stocks: The Place to be During Coming Inflation (+2K Views)

With governments having injected huge sums of money into their economies, more and more top strategists are becoming very worried about inflation. Words: 664

The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by John Reese (validea.com)

1. Does Inflation Mean Troubled Times for Stocks?
Many say high-inflation periods are indeed trouble for stocks. As inflation rises, governments will raise interest rates, the theory goes, and investors will flee stocks and head to Treasury bills.

The reality is much more complex. While history has shown that the stock-fleeing scenario can happen, it doesn’t always. In 1975, when U.S. inflation averaged 9.2%, the S&P 500 surged about 30% while 10-year U.S. Treasury bills averaged an 8% yield. In 1980, when inflation averaged 13.6% – the highest annual reading of the past 60-plus years – the S&P gained almost 30%, while 10-year T-bills yielded an average of 11.4% throughout the year.

Over the longer term, some of history’s top strategists actually say that inflation is a big reason to buy stocks – not to avoid them. Foremost among them is Warren Buffett. His inflation research goes way back. In 1977 – just before the U.S. was about to enter into one of the worst inflationary climates in history – in a column for Fortune magazine he said, “stocks are probably still the best of all the poor alternatives in an era of inflation – at least they are if you buy in at appropriate prices.”

Why keep your long-term focus on stocks if inflation is coming?

For starters, they have an overall advantage over fixed-income investments because of the equity risk premium – the notion that stocks return more than fixed income investments over the long haul because investors demand greater returns for taking on greater short-term volatility.

Just as importantly, when you factor in inflation, that advantage becomes even greater. When inflation hits, stocks can draw on increasing earnings streams as companies raise prices and increase profits to keep up with inflation. Most bonds and bills can’t do that and when inflation is factored in, the equity risk premium becomes crucial. Fixed-income investments, because their nominal yields are usually lower than nominal stock returns to begin with, have a much bigger percentage of returns eaten away by inflation.

In his book “Contrarian Investment Strategies” , David Dreman noted that from 1946 to 1996, compound returns after inflation for stocks were better than those of bonds 84% of the time if your holding period was five years. Stocks also outperformed T-bills in 82% of those five-year periods. Using 10-year periods, stocks beat bonds 94 per cent of the time and T-bills 86% of the time. When you look at 20-year holding periods, stocks beat both bonds and T-bills 100% of the time.

2. How Can You Position Your Portfolio to Deal With an Inflationary Climate?
If you knew, if and when, major inflation was going to set in and how long it would last, you might – and, I stress, might –be able to make some short-term profits by jumping back and forth between stocks and fixed-income investments but no one knows those factors in advance, which is why I’m sticking with stocks.

My Buffett-based approach targets stocks that have boosted earnings per share in at least 9 of the past 10 years, have 10-year average returns on equity of at least 15% and have positive free cash flows, all of which align with Mr. Buffett’s inflation-protection advice. My model is quite stringent, and currently gives 100% scores to less than a dozen stocks in the market.

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