What Inflation Means for Stock Allocation

If you’ve been investing only for the past 30 years or less, you could soon be facing an investment environment unlike any you’ve seen so far. On the other hand, if you’re an old-timer who has been buying stocks since the 1990s and 1980s or earlier, the coming environment will likely have a familiar feel.

We are approaching a major market inflection point. It will be a new day with new rules and new leaders. But at the same time, it’s also a return to a longer-term norm. Specifically, we’re on the cusp of transitioning to a market environment in which value stocks, those with low price-to-book ratios (among other valuation metrics) shine and outperform growth stocks.

While in recent decades investors have been accustomed to growth stocks, the likes of Microsoft (NSDQ: MSFT) and Alphabet’s Google(NSDQ: GOOGL), leading the way, over the longer term it has been value stocks racking up the biggest gains. Or to look at it another way, the market’s behavior for much of the past 30 years has been an anomaly. Put another way, the high-flying tech stocks in recent years may be in for tough times ahead.

What Does History Say?

We first analyzed the long-term patterns of growth stocks vs. value stocks in the April 2018 issue of The Complete Investor. In that study, going back as far as we had reliable data, we compared the performance of growth and value stocks for each decade starting with the 1930s. The table below reproduces and updates the table from that article.

(Due to the size of the table, the web page has automatically shrunk the resolution to make it fit into the space allotted. To view the table in its original size, right click on the table and select “open image in new tab” or “download image.”)

As it shows, in most decades value stocks significantly outperformed growth stocks. The overall comparison was 11.5% annualized gains for value stocks vs. 9.6% annualized gains for growth stocks. This means that for every dollar invested in a representative group of value stocks in 1927, you’d now have nearly $32,000, compared to around $7,000 per dollar invested in growth stocks.

Inflation and Stock Performance

But we didn’t merely show that value stocks outperformed; we also looked at why. One correlation stood out: inflation. During decades when inflation rose, which were most of the decades. value stocks rose to the fore. When inflation was quiescent, growth stocks grabbed the lead.

There are several reasons why that makes sense, but a basic one is that investors reward growth based on how far into the future they can confidently anticipate a company’s earnings. When inflation is rising, overall uncertainty rises as well, making it harder to have faith that, year after year, a company can achieve the growth that is implicit in a high P/E.

The correlation with inflation is extremely strong. From the 1930s through the 2010s, the correlation between the relative performance of value and inflation is a very high 0.8. It’s the same whether you are looking at small-cap or large-cap value.

Where We Go From Here

Now let’s look at the more recent past. During the past 30 years, inflation has been uncharacteristically low, and it has come to seem normal that growth stocks are the market leaders. But inflation now is rising. Nor is there any reason to believe the rise will be short-lived. In fact, there’s every reason to believe we’re entering a prolonged period of rising prices, driven by commodity shortages that already have emerged and that are going to worsen.

Read This Story: The Rise of The Commodities “Super-Cycle”

The past year has seen the most intense rise in broad-based commodities in a century or more. In fact, there has never been a one-year period in which commodity prices have risen by as much as in the past 12 months, when a broad range of commodities gained 50%. The rise was led by copper, one of the world’s most widely used commodities, which more than doubled.

Looking ahead, as inflation rises, we expect value stocks will start to outperform purer growth stocks. However, this doesn’t mean that value stocks will necessarily do better in the future than they’ve done in the recent past. That’s because as inflation picks up, the overall market will become more volatile and subject to greater stress. That clearly is nothing to cheer about, but it makes it more important than ever to be in the stocks best suited to this old/new inflationary environment, and that means an increasing focus on value plays.

Editor’s Note: Speaking of equity valuations… you’ve probably noticed that the tech-heavy NASDAQ currently hovers at a record high. Some technology stocks are great buys now. But many others aren’t. In fact, there’s a slew of much-hyped “story stocks” in the tech sector that are overbought and poised for a tumble.

Our colleague Jim Pearce, chief investment strategist of Mayhem Trader, has pinpointed the most vulnerable stocks in the tech sector and he has devised a simple way to leverage their imminent decline. Want to reap a windfall from Jim’s next trades? Click here for details.