How inflation, economic growth and stock prices are interlinked
Markets are influenced by human behaviour acting in herds; so it is tough to formulate laws that can explain market action, much less predict it accurately. But Ed Easterling has an interesting theory which he calls ‘financial physics’. Financial physics explains the interaction among the principles of economics and finance as the drivers for secular stock markets. In the financial physics model, two elements of economics—economic growth and inflation—drive the two financial components of the stock market, viz, corporate earnings and stock prices.
In the first set of correlation, economic growth is the fundamental driver of earnings growth which, in turn, is the primary driver of the stock market over the long term. Higher growth and higher inflation should increase corporate earnings. If inflation only bumped up earnings, the stock market would respond accordingly and move higher; but it does not.
This is where the second factor comes into play. While inflation increases earnings, it also affects the price levels of financial assets and the price level of a financial asset influences subsequent returns. Rising inflation increases the level of returns required by investors, thereby causing prices to decline. Stock prices fall as the present value of future earnings declines. To get a higher rate of return from stocks, investors tend to pay a lower price for future earnings (i.e., lower P/Es). In effect, inflation drives down P/E and, thus, offsets the inflation-driven growth in EPS.
Historically, the years with higher inflation and deflation tend to have a low P/E. When inflation is high, investors should expect that P/E would be low. If we are in a situation of higher-than-average-P/E, prices will fall—often, despite growing GDP and earnings. Similarly, in a scenario of deflation, the future growth rate for earnings and dividends turns negative and the value of stocks falls. Thus, both higher inflation and deflation cause P/E to decline. Higher inflation also reduces the purchasing power value of an investment portfolio. Thus, high inflation brings in low returns and lessens the value of what’s left. Easterling’s market valuation theory firmly makes the market level relative to the inflation rate—not a level that is arbitrarily anchored to a long-term average. This is precisely what is happening in the market today.
There are fears of rising inflation which are reflected in P/E compression—despite rising EPS (earnings per share) and GDP growth.
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