Edward Renshaw
Professor of Economics
State University of New York at Albany
A number of analysts have been perplexed by evidence that common stock returns and changes in the inflation rate have been negatively related to each other over long periods of time. In his (1981) review of the evidence Eugene Fama notes that, "These results are puzzling given the previously accepted wisdom that common stock, representing ownership of the income generated by real assets, should be a hedge against inflation." The inflation fighting policies of the Federal Reserve, however, will probably always make it safer to invest in stocks and bonds when other prices are increasing at a slower rate than when their inflation rates are accelerating.
In TablAe 10.1S we use the average first purchase price of US crude oil at the well head and the year-to-year percentage changes in the implicit price deflator for real GDP to dramatize the historical advantage of owning stocks when the inflation rate is stable or declining.
From 1942-94 there were 21 years when the price of crude oil remained the same or declined and in each of these years the financial return on the S&P index was positive. The data are generally supportive of a negative relation between stock returns and changes in the inflation rate but also indicate that the US stock market can sometimes respond in a favorable fashion to a large increase in the price of this commodity as was the case during the 1947-48 and 1978-80 periods when the price of crude oil nearly doubled and more than doubled.
There have been 20 years from the beginning of World War II through 1993 when the inflation rate for the implicit price deflator for real GDP expressed in 1987 dollars declined by .2 percentage points or more and in each of these years the financial return on the S&P index was positive.
The value of being able to correctly forecast large increases in the December-to-December CPI inflation rate is most apparent for the long term bond market. For the 13 years from 1955-90 when the first differences in this inflation rate were in excess of .7 percentage points the financial returns from holding corporate bonds ranged from a loss of 8.1 percent in 1969 to a high of only 6.8 percent in 1990 and have an average value of minus .77 percent. The comparable return from holding the S&P stock price index during these years was a slightly better average gain of only 1.7 percent. See Table 10.2S.
After the .7 percentage point threshold has been reached, however, there is little correlation between the magnitude of the first differences in the CPI inflation rate and the associated returns from holding bonds.
The Commodity Research Bureau's futures price index is computed on a daily basis, reported in the Wall Street Journal along with the Dow Jones futures index and is probably one of the most closely followed inflation indicators as far as professional Fed watchers are concerned. Thirteen of the 21 commodities in this index are agricultural products. The other commodities in the CRB future index are: copper, crude oil, gold, heating oil, unleaded gas, lumber, platinum and silver.
Yearly declines in the CRB futures index have usually been followed by positive returns for the S&P stock price index. The only exception (so far) since the CRB index was first computed in 1956 is 1989. If it hadn't been for Iraq's unexpected invasion of Kuwait during the summer of 1990, the financial return in that year might have been positive. See Table 10.3S.
It has been far more risky to purchase stocks after a yearly increase in the CRB futures index unless the Commerce Department's composite index of leading economic indicators was signaling a positive year for stocks. For the ten years from 1957-94 when neither the CRB futures index or the composite index of leading indicators were signaling a good year to own common stock the average financial return for the S&P index in the following year was a loss of 6.2 percent.
Fama, E. (1981). "Stock Returns, Real Activity, Inflation and Money,"American Economic Review, 545-65.
Average First % Change Financial
Purchase Price Implicit Price Return
US Crude Oil Deflator for S&P
Year (Dollars) Real GDP Index
(1) (2) (3)
1942 1.19 5.7 19.2**
1943 1.20 1.2* 25.7**
1944 1.21 1.1 19.3**
1945 1.22 5.3 35.7**
1946 1.41 25.3 - 7.8
1947 1.93 12.2* 5.5
1948 2.60 7.1* 5.4
1949 2.54* - .8* 17.8**
1950 2.51* 1.9 30.5**
1951 2.53 5.2 23.4**
1952 2.53* 1.1* 17.7**
1953 2.68 2.0 - 1.2
1954 2.77 1.0* 51.2**
1955 2.77* 3.2 31.0**
1956 2.79 3.4 6.4**
1957 3.09 3.3 -10.4
1958 3.01* 1.9* 42.4**
1959 2.90* 2.8 11.8**
1960 2.88* 1.6* .3
1961 2.89 1.2* 26.6**
1962 2.90 2.3 - 8.8
1963 2.89* 1.1* 22.5**
1964 2.88* 1.8 16.3**
1965 2.86* 2.5 12.3**
1966 2.88 3.5 -10.0
1967 2.92 3.1* 23.7**
1968 2.94 5.0 10.8**
1969 3.09 5.0 - 8.3
1970 3.18 5.4 3.5
1971 3.39 5.4 14.1**
1972 3.39* 4.6* 18.7**
1973 3.89 6.4 -14.5
1974 6.87 8.7 -26.0
1975 7.67 9.6 36.9**
Average First % Change Financial
Purchase Price Implicit Price Return
US Crude Oil Deflator for S&P
Year (Dollars) Real GDP Index
(1) (2) (3)
1976 8.19 6.3* 23.6**
1977 8.57 6.9 - 7.2
1978 9.00 7.9 6.4
1979 12.64 8.6 18.4**
1980 21.59 9.5 31.5**
1981 31.77 10.0 - 4.8
1982 28.52* 6.2* 20.4**
1983 26.19* 4.1* 22.3**
1984 25.88* 4.4 6.0**
1985 24.09* 3.7* 31.1**
1986 12.51* 2.6* 18.5**
1987 15.40 3.2 5.7**
1988 12.58* 3.9 16.3**
1989 15.86 4.4 31.2**
1990 20.03 4.4 - 3.1
1991 16.54* 3.8* 30.0**
1992 15.99* 2.8* 7.4**
1993 14.25* 2.2* 9.9**
1994 13.19* 2.1 1.3
*A positive financial return for the S&P index is indicated by a decline or no change in the average price of crude oil or by a decline in the inflation rate for the implicit price deflator for real GDP of more than .1 percentage point. The financial returns for the S&P index have been positive in these years.
**Years when the financial return exceeded the inflation for the implicit price deflator in column (2).
Source of basic data: Monthly Energy Review, BCI series 310 and Standard and Poor's Security Price Index Record.
Inflation Financial Returns
CPI Rate First ---------------------------
Year Inflation Rate Differences Corporate Bonds S&P Index
(1) (2) (3) (4)
1955 .4 1.1 .5* 31.0
1956 3.0 2.6 -6.8* 6.4
1957 2.9 - .1 8.7 -10.4
1958 1.8 -1.1 -2.2 42.4
1959 1.7 - .1 -1.0 11.8
1960 1.4 - .3 9.1 .3
1961 .7 - .7 4.8 26.6
1962 1.3 .6 7.9 - 8.8
1963 1.6 .3 2.2 22.5
1964 1.0 - .6 4.8 16.3
1965 1.9 .9 - .4* 12.3
1966 3.5 1.6 .2* -10.0
1967 3.0 - .5 -4.9 23.7
1968 4.7 1.7 2.6* 10.8
1969 6.2 1.5 -8.1* - 8.3
1970 5.6 - .6 18.4 3.5
1971 3.3 -2.3 11.0 14.1
1972 3.4 .1 7.3 18.7
1973 8.7 5.3 1.1* -14.5
1974 12.3 3.6 -3.0* -26.0
1975 6.9 -5.4 14.6 36.9
1976 4.9 -2.0 18.6 23.6
1977 6.7 1.8 1.7* - 7.2
1978 9.0 2.3 - .1* 6.4
1979 13.3 4.3 -4.2* 18.4
1980 12.5 - .8 -2.6 31.5
1981 8.9 -3.6 -1.0 - 4.8
1982 3.8 -5.1 48.5 20.4
1983 3.8 .0 1.1 22.3
1984 3.9 .1 16.4 6.0
1985 3.8 - .1 30.9 31.1
1986 1.1 -2.7 19.9 18.5
1987 4.4 3.3 - .3* 5.7
1988 4.4 .0 10.7 16.3
1989 4.6 .2 16.2 31.2
1990 6.1 1.5 6.8* - 3.1
1991 3.1 -3.0 18.2 30.0
1992 2.9 - .2 9.1 7.4
1993 2.7 - .2 12.4 9.9
1994 2.7 .0 -3.4 1.3
*Identifies bond returns during years when the price acceleration for the CPI was over .7 percentage points.
Source: Ibbotson and Sinquefield, Standard and Poor's, Salomon Brothers, and Johnson's Charts.
Year % Change Financial Returns S&P 500
Futures Current Following
Index Year Year
1973 47.6 -14.5 -26.0
1972 31.4 18.5 -14.5
1979 23.7 18.4 31.5*
1983 18.6 22.3 6.0*#
1978 13.6 6.4 18.4#
1993 11.6 9.9 1.3
1987 11.2 5.7 16.3#
1980 9.6 31.5 - 4.8
1988 8.3 16.3 31.2#
1976 7.2 23.6 - 7.2
1963 6.6 22.5 16.3
1961 5.9 26.6 - 8.8
1994-------4.6------ 1.3----- ?#
1969 3.1 - 8.3 3.5*
1965 1.6 12.3 -10.0
1974 1.6 -26.0 36.9*
1968 1.2 10.8 - 8.3
1971 .9 14.1 18.7#
1959 .5 11.8 .3
1962 .0 - 8.8 22.5#
1970 - 1.3 3.5 14.1
1966 - 1.7 -10.0 23.7*
1958 - 1.9 42.4 11.8*
1977 - 2.1 - 7.2 6.4#
1992 - 2.6 7.4 9.9
1990 - 3.2 - 3.1 30.0*
1967 - 3.8 23.7 10.8
1960 - 4.4 .3 26.6*
1964 - 5.3 16.3 12.3#
1985 - 6.1 31.1 18.5
1975 - 6.3 36.9 23.6*#
1991 - 6.5 30.0 7.4
1957 - 7.9 -10.4 42.4*
1982 - 8.2 20.4 22.3
1989 - 8.7 31.2 - 3.1
1986 - 8.9 18.5 5.7
1984 -12.0 6.0 31.1
1981 -17.4 - 4.8 20.4*
*Financial returns following years when the percentage change in the index of leading economic indicators was over 6 percent or under minus 2.1 percent.
#Financial returns following years when the percentage change in the index of leading indicators was positive and the average December value for the S&P index was 1.6 percentage points below its previous average monthly cyclical high.
Go on to Essay 11S:
Return to the Introduction