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25 February 2009

How much do investor expectations of increasing inflation affect the growth of stock prices?

That's the question we're introducing today, as we focus on the stagflationary era of U.S. economic history as we continue our backward march through time in considering the history of the stock market through the lens of the analytical tools provided to us from the world of modern industrial quality control.

Here is our "control chart" of the order that appears to have existed in the stock market from February 1976 through April 1980, followed by a period of disorder running until September 1981:

S&P 500 Average Monthly Index Value vs Trailing Year Dividends per Share, February 1976 through September 1981

In the chart above, we see that the period of "order" is one in which stock prices grew at a very slow rate, as the exponent in our modeled equation falls between a value of 0 and 1. What's more, we see that stock prices often declined during this period even as dividends per share rose, which contradicts the fundamental relationship that we've found exists between the two.

Before we go any farther though, this isn't the only time we've seen our exponent, the price-dividend growth ratio, fall between the values of 0 and 1. We've seen that previously for the period of order which existed between June 2003 and December 2007:

S&P 500 Average Monthly Index Value vs Trailing Year Dividends per Share, June 2003 through December 2007

With a price-dividend growth rate ratio of 0.7568, we confirm that the rate of growth of stock prices from June 2003 through December 2007 was much stronger than the nearly flat 0.0595 recorded for the period between February 1976 and April 1980. Both periods however fall well short of the price-dividend growth ratios that exceed a level of 1.0 that we've observed for sustained periods of robust growth in stock prices.

So, we have a bit of a puzzle. What could account for both the less than robust growth in stock prices for both 1976 through 1980 and 2003 through 2007, while also explaining why the rate of growth of stock prices between 1976 and 1980 is so much less than that we find between 2003 and 2007?

We don't know for sure, but we think that both the sameness and the differences we see in both these periods may be accounted for by what investors expected would occur with the rate of inflation in the U.S. economy. Let's take a look at the annualized rate of inflation from 1976 through 2007, as measured by changes in the Consumer Price Index for All Urban Consumers (CPI-U), to see what was going on throughout these periods:

Annualized Rate of Inflation in the U.S., January 1976 through January 2008

In this chart, we've indicated three periods in which the rate of inflation was consistently rising over periods of several years (we've marked the period between 1987 and 1990 for future reference since we're focusing more on the periods between 1976 through 1980 and 2003 through 2007 in this post.) Visually comparing the slopes of our two primary periods of interest, we see that investors were seeing inflation consistently rise throughout the two periods below with price-dividend growth ratios below a level of one.

What's more, we see that the relative steepness of the slopes we observe in the rate of growth of inflation would appear to be negatively correlated with the value of the price dividend growth ratio observed in both periods. Here, we suspect that the more steeply inflation rises, the lower our observed price-dividend growth ratio will be, as investors expecting higher rates of inflation would tend to bid stock prices downward, even as dividends per share rise.

This is a relationship that we'll be revisiting as we continue to march backward in time with our analysis of stock prices with respect to their trailing year dividends per share. Right now, we just don't have enough data points to make a firm conclusion, although the influence of investor expectations for inflation might make for a compelling explanation for differences we observe in the rate of growth of stock prices over time that aren't directly driven by the rate of growth of dividends per share.

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