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Can someone ELI5 why inflation causes the markets to go down rather than up? Wouldn’t cash lose more ground during inflationary periods than equities? The equit

Can someone ELI5 why inflation causes the markets to go down rather than up? Wouldn’t cash lose more ground during inflationary periods than equities? The equity in the underlying companies should be more resistant to inflation since the companies can and will raise prices to account for the inflation. And future earnings will also increase due to inflation lowering their P/E ratios. All this seems to point to increasing stock market exposure. If there’s a market sell off due to inflation, where are those dollars going?

omalleyt 5y ago
There's something called the equity risk premium. This is essentially the extra rate of return investors want to get in order to hold stocks rather than Treasury bonds. When inflation is high, the yield on Treasury bonds goes up. This means that, for the same equity risk premium, investors require a higher rate of return from stocks. Rate of return is approximately E/P (i.e. the inverse of P/E). So therefore, P/E must go down. This is called P/E compression. It's why stocks don't perform as well during inflationary periods as physical assets (such as gold, silver, real estate, etc.)
bijant 5y ago
If Inflation Markers are up, that increases pressure on the Federal Reserve to reduce QE and eventually even increase rates. When that happens liquidity will be removed from equity markets reducing valuations. If there were a smaller increase in Consumer Prices then the flow of liquidity into equities could continue unabated. That was the expectation. The markets are adjusting to these new facts on the ground.
nine_zeros 5y ago
> Can someone ELI5 why inflation causes the markets to go down rather than up? It's only going down relative to previous highs because institutional investors are expecting to be able to get better returns by lending instead of by investing in equity. The reason they expect to get better returns by lending is because they expect the FED to react to rising CPI by raising interest rates. > If there’s a market sell off due to inflation, where are those dollars going? Anything that returns more. Mostly towards lending to humans, businesses, funds, countries what have you. Maybe also towards commodities which are essential and people will continue to pay for them (oil, copper) Inflation hedges such as gold and more recently, crypto which is turning out to be an excellent hedge against US Dollar. All of this still sucks for anyone being payed in cash. We are all just puppets in financial games.
anewaccount2021 5y ago
The market is driven by cheap debt. Take away the cheap debt...
nostrademons 5y ago
The primary driver right now is the expectation that interest rates are going to have to rise in a couple years to combat inflation. The theoretical value of a stock is the discounted value of all future cash flows, right? If interest rates go up to 15% in 2 years because inflation is 10%, then you have to discount the cash flows (boosted by 10% because of inflation) at 15%, rather than the current 0%. In theory rates go down when inflation does, but investors don't know by how much, and in the 80s (our last historical example) they were still running ~8% even when inflation went to 3%. This is why growth stocks like tech have taken more of a beating than value stocks like food, oil, or defense. The former rely heavily on the expectation of future cash flows, often far off in the future, and if there's an incidence of extremely high interest rates between now and then, the value of those cash flows is significantly reduced even if their absolute amount increases because of inflation. If the Fed does not raise rates or is unable to control inflation, then it behaves as you describe: stocks become much more attractive than cash, and the rational price point for a stock becomes infinite. This is how the stock markets in Venezuela and Zimbabwe have behaved: they increase exponentially, measured in their native currencies, as the currencies depreciate exponentially. In other words, investors are pricing in rate hikes in response to inflation, and assuming that this will be "controlled" inflation that raises price levels a finite amount and then disappears. If either of these assumptions proves to be false, stocks are significantly undervalued.
- benlivengood 5y ago
  > This is why growth stocks like tech have taken more of a beating than value stocks like food, oil, or defense. The former rely heavily on the expectation of future cash flows, often far off in the future, and if there's an incidence of extremely high interest rates between now and then, the value of those cash flows is significantly reduced even if their absolute amount increases because of inflation. I thought that the value of many tech stocks was heavily based on growth. E.g. it's not worth waiting 10 or 20 years for a tech stock to start paying 3% dividends if the price stays the same; start earning 3% or more right now instead. In that sense, selling stock due to the risk of inflation is betting both that the company won't grow as fast inflation-adjusted as it did in the past (essentially the company can't perform as well under inflation) and that inflation will still be high when the stock starts paying dividends. I am definitely not a financial analyst, just confused.
deleted 5y ago
[deleted]
justinzollars 5y ago
Sure, think of it as a systems problem. the moves today are in relation to the move in the 10 year yield spike. Tech stocks are inversely correlated to increases in this yield and more specifically the steepening of the yield curve. The bond market is very large and moves in stocks can be understood with the yield curve: https://www.investopedia.com/terms/y/yieldcurve.asp https://www.investopedia.com/terms/y/yieldcurve.asp Gold went down today for a similar reason, it is strongly correlated to the real yield of a bond. Negative real yields favor gold.

omalleyt 5y ago

There's something called the equity risk premium. This is essentially the extra rate of return investors want to get in order to hold stocks rather than Treasury bonds. When inflation is high, the yield on Treasury bonds goes up. This means that, for the same equity risk premium, investors require a higher rate of return from stocks. Rate of return is approximately E/P (i.e. the inverse of P/E). So therefore, P/E must go down. This is called P/E compression. It's why stocks don't perform as well during inflationary periods as physical assets (such as gold, silver, real estate, etc.)

bijant 5y ago

If Inflation Markers are up, that increases pressure on the Federal Reserve to reduce QE and eventually even increase rates. When that happens liquidity will be removed from equity markets reducing valuations. If there were a smaller increase in Consumer Prices then the flow of liquidity into equities could continue unabated. That was the expectation. The markets are adjusting to these new facts on the ground.

nine_zeros 5y ago

> Can someone ELI5 why inflation causes the markets to go down rather than up? It's only going down relative to previous highs because institutional investors are expecting to be able to get better returns by lending instead of by investing in equity. The reason they expect to get better returns by lending is because they expect the FED to react to rising CPI by raising interest rates. > If there’s a market sell off due to inflation, where are those dollars going? Anything that returns more. Mostly towards lending to humans, businesses, funds, countries what have you. Maybe also towards commodities which are essential and people will continue to pay for them (oil, copper) Inflation hedges such as gold and more recently, crypto which is turning out to be an excellent hedge against US Dollar. All of this still sucks for anyone being payed in cash. We are all just puppets in financial games.

anewaccount2021 5y ago

The market is driven by cheap debt. Take away the cheap debt...

nostrademons 5y ago

The primary driver right now is the expectation that interest rates are going to have to rise in a couple years to combat inflation. The theoretical value of a stock is the discounted value of all future cash flows, right? If interest rates go up to 15% in 2 years because inflation is 10%, then you have to discount the cash flows (boosted by 10% because of inflation) at 15%, rather than the current 0%. In theory rates go down when inflation does, but investors don't know by how much, and in the 80s (our last historical example) they were still running ~8% even when inflation went to 3%. This is why growth stocks like tech have taken more of a beating than value stocks like food, oil, or defense. The former rely heavily on the expectation of future cash flows, often far off in the future, and if there's an incidence of extremely high interest rates between now and then, the value of those cash flows is significantly reduced even if their absolute amount increases because of inflation. If the Fed does not raise rates or is unable to control inflation, then it behaves as you describe: stocks become much more attractive than cash, and the rational price point for a stock becomes infinite. This is how the stock markets in Venezuela and Zimbabwe have behaved: they increase exponentially, measured in their native currencies, as the currencies depreciate exponentially. In other words, investors are pricing in rate hikes in response to inflation, and assuming that this will be "controlled" inflation that raises price levels a finite amount and then disappears. If either of these assumptions proves to be false, stocks are significantly undervalued.

benlivengood 5y ago
> This is why growth stocks like tech have taken more of a beating than value stocks like food, oil, or defense. The former rely heavily on the expectation of future cash flows, often far off in the future, and if there's an incidence of extremely high interest rates between now and then, the value of those cash flows is significantly reduced even if their absolute amount increases because of inflation. I thought that the value of many tech stocks was heavily based on growth. E.g. it's not worth waiting 10 or 20 years for a tech stock to start paying 3% dividends if the price stays the same; start earning 3% or more right now instead. In that sense, selling stock due to the risk of inflation is betting both that the company won't grow as fast inflation-adjusted as it did in the past (essentially the company can't perform as well under inflation) and that inflation will still be high when the stock starts paying dividends. I am definitely not a financial analyst, just confused.

deleted 5y ago

[deleted]

justinzollars 5y ago

Sure, think of it as a systems problem. the moves today are in relation to the move in the 10 year yield spike. Tech stocks are inversely correlated to increases in this yield and more specifically the steepening of the yield curve. The bond market is very large and moves in stocks can be understood with the yield curve: https://www.investopedia.com/terms/y/yieldcurve.asp https://www.investopedia.com/terms/y/yieldcurve.asp Gold went down today for a similar reason, it is strongly correlated to the real yield of a bond. Negative real yields favor gold.