There are three powerful forces driving the stock markets. They are corporate earnings, inflation and interest rates. Together, they make the stock markets act or react or pro-act to their force. They are related, but independent. They are measurable but not accurately so. Nobody has understood them fully. They convey the effects of all that happens, and ultimately determine the fate of the market.
Corporate earning is the first powerful force driving the stock markets. They command a price and people are willing to pay more than its fair value for it. It is not a static force, but a dynamic one, ever-changing and influenced by the underlying macroeconomic environment.
One of the macroeconomic factors that can change earnings substantially is inflation. An increase in inflation causes raw materials, labor and overhead costs to increase. Companies have to increase productivity and/or raise prices to overcome the effects of inflation. Any artificial controls in pricing products like government intervention or inability to hike selling prices narrows down profit margins. Returns tend to be overstated due to inflation.
Inflation is the second powerful force driving the stock markets. Stable and moderate inflation means a higher probability of continued economic expansion. Modest inflation implies that the central bank will not increase interest rates. During times of low inflation the quality of earnings is higher as inflation does not eat away the earnings.
A rising inflation however stifles investments, weakens the economy, and hurts corporate earnings. Inflation not only lessens the value of financial assets, it erodes the purchasing power of investors. Investors are willing to pay less for the certain level of earnings when inflation is high and more for the same level of earnings when inflation is low.
A low inflation and low interest rate economy will have higher real earnings growth. This increases the amount people are willing to pay for earnings, thereby leading to higher P/E ratios.
Left unchecked, inflation destroys monetary stability, and leads to a weak economy. Reserve Bank of India increases interest rates to control inflation and reduce liquidity in the system. So, as inflation increases, the interest rates go up and stock prices fall. This leads us to the third force.
The third and perhaps most powerful force driving the stock markets is the interest rates. Interest rates cause stock prices to rise and fall. Stock prices go up when interest rates go down, and fall when interest rates go up. Ironically, higher interest rates also raise costs for companies. Funding costs increase and threaten capital expansion, thereby stifling growth.
So, the overall effect is stock prices rise when earnings go up. Stock prices fall when inflation rises, and stock prices fall when interest rates increase. Stock value increases when earnings per share, profitability, and earnings growth rate go up. Stock value decreases when interest rates and inflation go up.
Conventional theory holds that equity should be a good inflation hedge as it’s a claim on real assets and not nominal assets. A true inflation hedge is one that goes up in value with higher inflation like a house, gold or collectibles. But, is stock a hedge against inflation?
The fact is investors can make money in stocks faster than inflation will eat it up. Over the long run, a company’s revenue and earnings should increase at the same pace as inflation. In the long term, stocks are a good protection against inflation. However, in the short term it may not be so.
As an investor, you must look at your real rate of returns while investing. Unfortunately, many investors look only at the nominal returns and forget about their purchasing power altogether.