Over the years the US stock market has been one of the best places to invest, providing that you are in for the long term. Interest bearing investments like AAA corporate bonds or US Treasuries provide a reliable return but when inflation is high these vehicles often provide negative real interest rates. Thus the common belief is that stocks are a better choice for combating inflation. However, when inflation is below 4% stocks work as a hedge and above 4%, they tend not to. Thus we have to think about investing when inflation is over 4% in a different light than when inflation is more moderate.
Are Stocks an Inflation Hedge or Not?
Bloomberg published an article noting that, according to Credit Suisse, when inflation is entrenched at about 8% that over the decades it has been extremely difficult to bring down and stock investment returns suffer. In years when inflation ranks in the top 5% of all years, stocks have fallen by an average of 9.6% in terms of real value. In the next top 15% of inflation years stocks have averaged a 0.7% return in real value adjusted for inflation.
How Do Interest Rates Affect Stock Investing
In general, higher interest rates encourage investors to put part of their portfolio in bonds, CDs, or Treasuries. Investors typically do this because these interest bearing investments are more secure in the short term as they are immune from stock market volatility. Another good reason to pivot to these vehicles is that when interest rates are going up stocks tend to perform poorly and it is when rates are going down that they do better.
The US stock market averages a 2.6% return on investment during periods of rising rates and a 9.6% return on investment as rates are going down. What investors need to be aware of is that these are average returns. There is a split between good years and bad years in these numbers as stock market returns can rise with interest rate increases and fall when rates are lowered. This means that the investor needs to consider specific cases and the intrinsic value of each stock in their portfolio.
Which Group of Stocks Does Best As Interest Rates Rise?
Over the years in rising interest rate environments the stocks that do the best are the cheapest. In this case we are not talking about penny stocks but entire markets or market niches that are undervalued in comparison to other markets or niches within a given market. The folks in the Bloomberg article note that the UK stock market is relatively undervalued and, as a rule, offers better dividend yields than the US market. So, if you follow their advice, you will look at the UK market or undervalued segments of the US market and dividend stocks within those markets.
Are You Investing for the Short Term or the Long Term?
A basic question that every investor needs to constantly ask themself is if they are looking for short term gains or best performance over the long haul. This brings us back to the fact that the US stock market has outperformed other investments for investors who choose good stocks with good intrinsic value and hold them for years and years. This does not mean that timing your investments is not important. We just saw Warren Buffett, whose preferred time to hold a stock is forever, sell the bulk of his shares in Taiwan Semiconductor. We have noted that bear markets can be the key to future wealth if the investor buys the right stocks when they are discounted. Thus, an investor needs to avoid gutting his portfolio of stocks that are promising for the long term simply because the economy, and the market are going through a period of inflation and rising interest rates.
Investing When Inflation Is Over 4% – SlideShare Version