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Stocks & Inflation: A game of cat and mouse

Dec 18, 2008

Stock market investors, as a whole, detest the idea of inflation. Stock prices commonly react negatively to a spike in inflation. The question is, why does it happen? Is it not true that for a good business, as the prices of inputs like raw materials increase due to inflation, so do the prices at which the company finally sells its products. In that case, inflation should not be that worrisome to owner of a business, because stocks would then become a hedge against inflation. But there is another angle to it. How attractive an investment opportunity is to you all depends on the attractiveness of the return that you get from it. But that attractiveness of the return is relative. It depends what else is on offer. If you are getting a 15% return on a particular kind of asset you own, it might seem satisfactory to you. But if someone else offers you a higher, say 18% return, then you place lesser value on the 15% you were getting earlier. Conversely, you would place a higher value on the asset that lets you earn an 18% return.

It is common knowledge that one of the most favored tool used by the government to reign in inflation is to increase interest rates. Thus when inflation rises, interest rates rise, and consequently the risk free rate of return you would get on government securities increases.

Consider two scenarios.

One where the risk free rate of return is 5% and the return that your business is earning, the return on equity (ROE), is 12%.

The second scenario, where the risk free rate of return becomes 10%, and the long-term returns your business has been achieving is 12%.

Even though the returns your business is making remains static at 12% in both cases, you would obviously find the 12% in the first scenario much more attractive. That is because of the fact that it is much higher than the return you would get buying the government bond. But in the second case, the return you would get from owning the business is very close to the returns you would get otherwise by buying government bonds. That too risk free. Thus the value you place on the 12% return you get from your business in the second scenario will be much lesser.

So ultimately, the price you are willing to pay to buy such a business depends on how much you value the business, which in turn depends on the attractiveness of the returns you get from that business relative to what is the risk free rate that is on offer. And that is how prices people are willing to pay for a stock fluctuate according to inflation.


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