Sunday, June 08, 2008

Focus on direction of inflation, not the rate

Alright. Inflation is high. So what do you do? Dump stocks and run?

“Don’t!” - Says Paul J Lim, in this NYT article.

Quoting some expert arguments, he concedes –

a) inflation devalues corporate earnings that drive stock prices. But the mere presence of inflation also suggests that many companies are successfully passing along price increases to customers. The returns from stocks will be far better than bonds. In the 23 calendar years between 1926 and 2007 when inflation measured more than 4 percent, stocks returned 6.9 percent on average, versus just 2.8 percent for long-term government bonds.

b) Analysis reveal during inflationary periods, most sectors outperform and are a sure long term hedge against inflation.

c) Observe the direction of inflation. High rate of inflation that heads southwards is a far better time to be in stocks than low rates of inflation that is heading northwards. In periods when the inflation rate fell, stocks soared by an average of nearly 10 percent.

d) There’s a perfect inverse relationship between core inflation and stock market valuations. Since 1960, whenever core inflation has hovered between 2 and 3 percent, the average P/E ratio of the S.& P. 500 has been 19.7, based on trailing 12-month earnings. But when core inflation jumps to between 4 and 5 percent, the average P/E falls to 14.8

So now you know what to do. Don’t dump your stocks. Just keep’em and you’ll be better off. (Because if you sell, I am not liquid enough to buy :-)

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