Inflation and the Stock Market

Abstract

Purpose – The main purpose of this project is to test how inflation (level and direction) affects the US stock market, and, subsequently, to uncover any structural market and economic conditions explaining the relationship. Specifically, this project intends to study the relation between expected inflation and forward P/E as well as actual and unexpected changes in inflation (direction and level) in relation to real returns in the market. Design/Methodology/Approach – The project applies a quantitative research method, applying primarily longitudinal analysis and interpretation to empirical stock market data in the period 1881-2021. In order to quantify, clarify and analyze the relationship between inflation and stock market returns and P/E, a historic estimate for both expected and unexpected inflation has been modelled, using secondary data retrieved from various sources of official publicly available data. Major Findings – The study finds a negative power-function relation between expected inflation and forward price-earnings relationship, implying maximum P/E ratios are reached when the level of inflation is low and steady (between 0%-2%). Furthermore, the study finds that real stock market return (as far as inflation is concerned) is dependent on the inflationary environments it is in; High (rising) levels of inflation caters for negative real returns whereas high (declining) levels of inflation caters for positive real returns. Lastly, sustained positive unexpected inflation shocks (an inflationary regime) typically results in a negative real return during the period followed by an economic recession. Research Implications & Academic Value – The study has contributed to the body of academic knowledge by outlining the conditions wherein inflation affects the US stock market. Furthermore, the study shows how structural changes and market conditions have developed over time, and how this has affected the relationship between inflation and real stock returns.