Over the past year, the U.S. has experienced elevated inflation rates that have driven up costs for products and services. With November’s inflation rate reaching 7.1%, these higher prices may have you wondering how inflation affects the stock market.
Both investors and consumers are monitoring inflation closely. Higher prices and stock prices lack an obvious connection at first glance. We’ll examine inflation, stock market returns, and strategies to protect your stock investments during inflationary periods.
What is Inflation?
Inflation occurs when the price of goods and services increases. When inflation rises, your purchasing power declines unless your income rises at the same rate.
The government implements monetary policy measures to control inflation. Left unchecked, rising inflation could damage employment and economic growth.
How Inflation Works
For sustainable economic growth, inflation should increase gradually across the economy. The Federal Reserve targets an annual inflation rate of 2%.
The inflation rate is measured using indicators such as the personal consumption expenditures price index (PCE). Extended periods of high inflation signal an overheated economy.
This inflationary environment develops when consumer demand outpaces supply, resulting in rising prices called demand-pull inflation.
Another scenario leading to higher prices involves supply chain disruptions that increase the cost of goods. This is known as cost-push inflation.
In both cases, prices will continue rising until spending decreases. When spending falls dramatically, the economy can enter a recession.
Inflation and Interest Rates
Rising inflation doesn’t necessarily mean stock prices will be negatively impacted. Corporate profits may increase, particularly for companies that pass along higher costs through price increases.
However, higher interest rates have the opposite effect on stocks. When inflation rises, the Federal Reserve typically raises interest rates.
This makes credit more expensive for consumers and companies, discouraging investment and spending.
Low Inflation and the Stock Market
The stock market responds to multiple factors, with inflation being one key input. Sustained periods of low to moderate inflation between 1-3% create the optimal environment for stocks.
In this balanced state, supply and demand remain at healthy levels while prices for goods and services stay stable. Currency value erosion remains at an acceptable level.
Generally, growth stocks tend to outperform value stocks during low inflation periods.
What happens with Stock Prices during Inflation?
During high inflation, value stocks typically outperform growth stocks. However, valuation concerns during inflationary periods tend to pressure the overall stock market downward.
The cost of money and capital increases during high inflation. Rising interest rates mean debt-laden companies face greater vulnerability. Consequently, high-growth stocks from companies with substantial debt suffer during periods of high inflation and interest rates.
Volatility
Stock markets become more volatile during periods of higher inflation and interest rates. Here’s an example of potential portfolio impact when inflation increases:
If your stocks deliver a 6% return while inflation runs at 8%, subtracting nominal return from inflation leaves you with -2%. This demonstrates why diversified portfolios become crucial when inflation rates climb.
Two consecutive periods of negative economic growth often coincide with high inflation, creating a high probability of recession.
During recessions, investors typically shift their approach, with sentiment favoring less risky investments for their stock portfolios.
What you should know about Value vs. Growth Stocks
Certain stock types demonstrate greater resistance to inflation’s impact. During high inflation periods, a solid investment strategy should emphasize value stocks.
These stocks tend to outperform growth stocks when interest rates climb. Let’s examine how value stocks and growth stocks function differently.
How Value Stocks Work
Value stocks are typically less expensive stocks from companies with low price-to-earnings (P/E) ratios. This ratio compares the company’s current share price to earnings per share.
Sometimes, a low P/E ratio indicates undervaluation. However, this ratio doesn’t always signal poor performance.
When evaluating value stocks, review multiple performance indicators including dividends, earnings, and sales.
These company fundamentals should align with the lower share price and actual performance, revealing whether the price reflects genuine undervaluation.
Mature yet steadily growing companies with stable earnings and revenues often qualify as value stocks. These stocks typically pay consistent dividends and deliver higher long-term returns.
How Growth Stocks Work
Growth stocks typically command higher prices than value stocks. Companies classified as growth stocks are expected to expand faster than average.
Investors drawn to these stocks believe the company possesses strong potential for future growth. The prospect of substantial future cash flows upon selling drives their motivation.
Unlike value stocks, growth stocks typically don’t pay dividends. If you seek regular or fixed income, growth stocks probably aren’t suitable investments.
Growth stocks often maintain a strong presence within their respective industries.
How to Invest in the Stock Market during Inflation
As an investor during high inflation periods, you’re experiencing its effects firsthand through your wallet. Rising price levels for goods and services reduce your purchasing power.
However, these periods don’t have to derail your financial goals entirely. Here are strategies to navigate these challenging times:
Choose a Strategic Investment Strategy
Consider implementing dollar-cost averaging during volatile times. This strategy involves investing a fixed amount in a security at regular intervals, helping reduce the overall investment cost.
When investing in stocks, you’re purchasing company shares. Stock prices fluctuate, rising and falling at various times.
Dollar-cost averaging involves investing a fixed amount regularly—weekly or monthly. This approach averages your per-share cost and reduces overall investment expenses.
Don’t Get Emotional about Stock Market Performance
Rapid stock price fluctuations can easily trigger anxiety and emotional responses.
Avoid major mistakes like exiting the stock market during turbulent times. When markets rebound, you could miss significant opportunities. A long-term buy-and-hold strategy works best.
Diversify your Portfolio
Build and maintain a diversified portfolio during both low and high inflation periods. Avoid concentrating too heavily in either value or growth stocks.
Consider your risk tolerance and utilize various asset classes to construct a robust portfolio.
Additionally, review your investment portfolio regularly. If you work with a financial advisor, they should help ensure your portfolio continues functioning as intended.
Rebalancing may be necessary if your allocated stocks, bonds, and cash proportions have shifted. Your investment portfolio should align with your investment objectives and risk tolerance.
Plan a Long-Term Strategy
Remember that we invest primarily because of inflation. The S&P 500 Index delivered an average annual return of 10.49% from 1926 to 2021.
During inflationary periods, we may feel unprepared for price increases and how inflation erodes our disposable income. However, with a long-term investment strategy, you’ll be positioned to keep pace with inflation.
