Building on the concepts presented in my Dividends Are Different article, here we present data and observations highlighting the relationship between inflation and 1) company fundamentals, 2) dividends, and 3) stock market movements.(1) We look at empirical data to investigate how inflation relates to market prices, earnings, and dividends. We measure results over 25-year time periods – fairly typical horizons for retirement planning. Our findings in Figure 1 reveal a strong relationship between fundamental performance (i.e., dividend growth or earnings growth) and inflation, but a weaker linkage between market returns and inflation. The figure above raises some natural questions that I’ll address in this piece. We’ll look at why this relationship holds in theory and then conduct a deeper dive into the data to get a better understanding what is going on under the hood.
Theory relating inflation to stock price movementsWhen it comes to investing for retirement, conventional wisdom holds that allocations to stocks generally facilitate growth that helps hedge against inflation.(2) The following highlights what we believe are the key fundamental and market-based mechanics that drive this relationship. At the root level, shares of stock represent profit-seeking enterprises and these businesses require capital to acquire resources (e.g., PP&E(3), raw materials, and labor), alter or assemble them, and turn them into something they can sell to their customers. This capital naturally demands a return. Thus, as inflation increases input costs, maintaining the required return on this capital will increase the absolute level of profit. Put simply, profits should rise with inflation under these assumptions. Of course, economic forces do not follow a set schedule or formula. Innovation and competition involve much trial and error. Moreover, companies ultimately rely on humans to make decisions. On an individual basis, this introduces some subjectivity into their fundamentals. However, the level of entropy is increased as they interact and create feedback loops. The bottom line is that the inflation-profit model described above will naturally involve significant noise. Notwithstanding this randomness, as long as survival instincts, profit motives, and competition exist, the above logic regarding returns on capital will apply and help explain why profits, and thus stock prices, should be positively correlated with inflation over the longer term.
While the relationship between inflation and profits is already noisy, market-based forces make the relationship between inflation and stock prices more tenuous. We firmly believe prices follow fundamental performance over the long term. However, investor sentiment(4) can influence prices over shorter periods. This notion is particularly relevant in the context of inflation. Historically, we have witnessed periods where investors reacted negatively to significant bouts of inflation and we suspect that is due to them assuming (implicitly or explicitly) a higher interest rate is warranted for discounting future cash flows. However, this reaction ignores the phenomenon we highlighted above and will illustrate below with historical data – i.e., that inflation appears to give rise to an increase in nominal profits over the longer term.
“In the short run , the market is a voting machine but in the log run, it is a weighing machine.”Benjamin Graham (Warren Buffett’s mentor)
In the context of retirement, inflation can require one to withdraw more money to maintain the same standard of living. Moreover, the threat is magnified to the extent that a sustained uptick in inflation can increase prices for the remainder of one’s retirement. Even worse, negative market reactions during inflationary periods can add further risk to this situation. On the one hand, inflation may force an increase in the dollar amount of portfolio withdrawals. On the other hand, each dollar of withdrawal may require selling more shares or bonds in an environment where their prices are depressed. This is why academics and practitioners view inflation as such a significant threat to retirement security.
“Inflation is truly the great enemy of the retiree.”William Bengen(5)
Empirical resultsThe goal of this section is to illustrate the historical relationship inflation has had with corporate fundamentals (i.e., earnings and dividends) and stock prices. We use Robert J. Shiller’s online data for S&P 500™ prices, earnings, and dividends. We start out by investigating these relationships over 25-year time periods as we believe this can help us address some of the noise highlighted above and identify longer-term trends. Moreover, 25 years is a reasonable period to consider in the context is retirement planning. Figure 1 (above) shows how stock prices, earnings, and dividends were correlated with inflation over 25-year periods. It shows impressively strong relationships between fundamental performance and inflation, but an unsurprisingly weaker linkage between market returns and inflation. S&P 500 returns were 58% correlated with inflation while earnings and dividends exhibited correlations of 64% and 83%, respectively. We also calculated how volatile these quantities were by measuring the standard deviation of their growth rates.(6) Figure 2 above shows these results. CPI exhibited the least volatility with a standard deviation of 4.6%. We suspect this primarily due to the slow-moving forces of supply and demand, but hedonic adjustments to CPI figures(7) and central bank mandates for price stability may also be factors. The standard deviations for dividends, earnings, and S&P 500 prices were all higher at 10.7%, 27.5%, and 17.9%, respectively. Interestingly, earnings showed the highest volatility. We believe this is due to the apples-oranges nature of the comparison. For example, each earnings figure represents the profits of the underlying companies reported over a particular period. However, market prices represent an average of expected earnings over many different periods. Moreover, earnings figures can be arbitrarily small over some periods (no negative readings in the data we used). Thus, percentage-based growth figures calculated from lower levels may accelerate rapidly. It is also worth noting that dividend volatility might also be lower due to the discretion CEOs and CFOs have in declaring dividends. Indeed, they have the ability to dig into retained earnings and pursue what they expect will be sustainable dividend policies despite fluctuations in their earnings. Even if earnings exhibited the highest correlations with CPI or the lowest level of volatility, earnings are not accessible, except to the extent they are paid out as dividends. That is, only share prices and dividends represent tangible, liquid money investors can use for spending. As such, earnings are effectively irrelevant in the context of retirement where one requires liquidity. Figure 3 above provides two visualizations of the 25-year growth rates for S&P 500 dividends and the consumer price index (CPI). The first chart on the left shows how the 25-year growth rates for dividends and CPI evolving through time. While they broadly followed each other, the most recent data show inflation trending lower while dividend growth rates have sustained their near-peak levels. The second chart shows the same data in scatter chart. We believe this chart reveals at least one key point. In periods where CPI grew the most (data points to the right), dividends also grew at a significant rate. This would have been particularly important to those relying on dividends for retirement income since the growth in dividends would have been there when it was needed most. The above calculations utilized growth rates from 122 overlapping 25-year windows spanning the 1872-2019 period. In particular, each growth rate depended only upon its starting and ending value. Thus, even if the dividend/inflation correlation of 25-year windows was high, the intra-period trajectories of these quantities could be divergent. Figure 4 in the left panel below illustrates a hypothetical example of a period whereby the end result was the same for two quantities, but the trajectories were very different. In order to assess the relationship between dividends and inflation at a higher resolution (i.e., within the 25-year periods), we made similar observations over smaller periods. Figure 5 shows the correlations calculated for rolling time periods ranging from five to 25 years. To be clear, the 25-years correlations in Figure 5 are the same as those presented in Figure 1. As expected, correlations increase with longer time periods. We attribute this to the noise we highlighted while discussing the theoretical underpinnings of this relationship (e.g., companies might temporarily absorb price increases before passing them on to their customers). Dividends show the highest correlations regardless of the time period chosen. Moreover, while not shown here, correlations between CPI and dividends fell to 34% for one-year time periods but increased to 95% with 50-year periods. On balance, we believe this indicates a strong relationship between dividends and inflation. To summarize, we highlight a few key points related to inflation:
- Natural economic forces impose a cause-and-effect relationship that makes inflation positively correlated with corporate fundamentals and stock prices.
- Relative to market prices and earnings, dividends have been the least volatile and exhibited the strongest correlations with inflation.
- We believe these relationships are likely to sustain and dividends can provide a robust option for retirees and other investors seeking income that will keep up with inflation.
Concluding remarksThis article first presented our theoretical model for how inflation relates to both corporate fundamentals and share prices. We then shared empirical results showing how dividend growth has been more strongly correlated with inflation than stock market returns or earnings growth. We believe the dividend-inflation trends we highlighted represent a visible hand of capitalism at work as required returns on capital effectively push inflation through the economy’s profit mechanism. While we find these results interesting from a theoretical perspective, they have important applications. For example, retirees who seek to manage their inflation risk via financial assets (versus human capital, which has been exhausted), can leverage the inflation-hedging benefits of dividends to their advantage.
|↑1||It may be worth summarizing the argument for why dividends may be fundamentally different than stock repurchases (after controlling for taxes, empire-building issues, signaling, and so forth). The basic premise is that dividend distributions are tied to company fundamentals, but synthetic dividends are subject to the stock price movements, which can be driven by sentiment swings leading to inefficient market prices. For example, Robert Shiller, the co-2013 Nobel Prize winner, highlights that stock markets don’t seem to reflect fundamental value — prices simply move way more violently than the underlying fundamentals. In short, the volatility of the underlying present value of free cash flows is much lower than the volatility of stock prices, which are supposed to reflect the underlying present value of free cash flows. We can visualize Prof. Shiller’s main point via the figure from his classic 1981 AER paper: So stock markets appear inefficient and subject to sentiment, or “noise.” What’s wrong with noise? Well, if we assume market prices don’t simply reflect the intrinsic value of free cash flows and are subject to so-called “noise trader risk,” we must ask if the noise risk has a price associated with it. Turns out that sentiment-driven market movements should probably earn a risk-premium. The arguments for this concept are outlined in a paper called, “Noise Trader Risk in Financial Markets.” If we identify dividend payment volatility as being directly tied to company fundamentals and stock prices as being loosely tied to company fundamentals plus risky noise, then all else equal, dividends are arguably different than synthetic dividends.|
|↑2||see this Asness paper for a discussion.|
|↑3||PP&E stands for property, plant, & Equipment|
|↑5||This quote comes from Chapter 1, page 14 of William Bengen’s book Conserving Client Portfolios During Retirement|
|↑6||We calculated intra-period standard deviations for each 25-year window and took an average. Standard deviations calculated over the entire 1872-2019 period show similar results, but we chose to present the average of intra-period standard deviations to account for potentially changing inflation regimes (i.e., the mean used to calculate each standard deviation was more specific to that particular period – not a universal average).|
|↑7||Hedonic adjustments attempt to remove price changes due to the changing quality of the underlying goods. You can read more about hedonic adjustments here.|