Continued from Part One

In Part One, we took a look at how stock market returns for Large Cap and Small Cap stocks are impacted by inflation. I showed linear regressions for the S&P 500 (Large Cap stock index) and the S&P 600 (Small Cap stock index) for various time frames, but we focused on the period of time in the 70’s and 80’s where the country last had an inflation problem.

The correlation analysis showed that there was a negative correlation between the broad stock market indices and inflation, meaning that Large Cap and Small Cap stock prices are negatively impacted by inflation as represented by the Consumer Price Index.

Today, we are going to perform the same analysis, except with the Dow Jones Industrial Average (representing the dividend paying value stock style of investing) and the NASDAQ 100 (representing the growth stock style of investing).

Dow Jones Industrial Average (Value Stocks)

Whereas we looked yesterday at the broad market, the DJIA is a more narrow index that represents, in large part, blue chip dividend paying stocks that should be a part of everyone’s retirement.

As we did yesterday, we are focusing on the time period of 1975 to 1986 (for more in depth on why we chose this time frame, please see Part One).

Here, again, we have a negative correlation between dividend paying value stocks and inflation. Given the results that we saw with the S&P 500, this should not be a real surprise since during this time period, the stocks that made up the bulk of the S&P 500 weighting were dividend paying value stocks. It is a recent development that the S&P 500 is now so heavily weighted by the high tech giants that dominate the NASDAQ 100, which leads us to examine its correlation with the CPI.

NASDAQ 100 (Growth Stocks)

Before we look at the graph, I think we need to remember that in the 70’s and 80’s, the NASDAQ 100 was quite a different index than it is today. Apple listed itself on the NASDAQ in 1980, and that was arguably the genesis of today’s technology dominant index.

This somewhat surprised me. We finally have found a part of the stock market that has a positive correlation with inflation. However, given that the makeup of the NASDAQ during this time period is so different than it is today, I wanted to look at other growth stocks vehicles to see if we have a similar pattern. Unfortunately, finding data on annual returns is challenging. I did, however, find that one of the premier growth stock mutual funds publishes their returns back to this time period: Growth Fund of America.

Even though it is not as dramatic a correlation, we still observe that a positive correlation exists between growth stock returns and inflation.

Let’s try one more classic growth story to see if it supports this theory: Berkshire Hathaway.

Again, we see a positive correlation between a growth stock and inflation.

Implications

This analysis presents a quandry. Historically, as an economy has come out of a recession and economic growth has taken off, value stocks – particularly cyclical stocks whose earnings increase during the positive phase of the economic cycle – outperform growth stocks. I’ve written about that here on the blog recently, but increasing economic activity will typically bring an increase in inflation, which seems contradictory with the data presented here.

I think what we have is a situation where not all value stocks are created equally. So here is my theory:

• (1) as an economy is ramping up GDP growth coming out of a recession, it has a positive impact on earnings growth in cyclical stocks while at the beginning of the recovery, inflation is tame.
• (2) Then as we move through the recovery and inflation starts to build, the impact to earnings growth for the part of the value stock universe that is cyclicals begins to ease
• (3) and the part of the value stock universe that is positively impacted by inflation takes over ( we are going to look at energy, miners, chemical producers, ag companies, and precious metals in this blog series to see if there is a positive correlation, but for purposes of this theory we will assume it exists).
• (4) Additionally, as cyclicals start to lose steam and inflation plays heat up, investors begin to look for consistent earnings growers in the growth stock universe and growth stocks perform in the late recovery phase as inflation is peaking, giving growth stocks a positive correlation with the CPI.

Whats Next?

Since we mentioned it above, the next post will analyze the types of companies that we assume benefit from inflation: energy, miners, chemical producers, ag companies, and precious metals.

If you ever feel like the investment world is overwhelming or you tire of winding your way through the choices, please contact me. We can discuss your situation and set up an investment portfolio that meets your objectives.

—Mark