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Inflation could spoil market's comeback party The stock market continues to sputter within a range. The Dow Jones Industrial Average is teetering just above the 10,000 mark and the S&P 500 hops back and forth over the 1,100 threshold. No firm rally can take hold, as investors are demanding to see earnings improvement. This improvement remains elusive. In aggregate, first quarter corporate earnings results have been unimpressive. Further trying investors' patience is the uncertain timetable for an improved business and earnings climate. However, once an improved earnings environment does take hold, these earnings will be evaluated in the context of inflation. If inflation becomes a force to be reckoned with as the year progresses, about the time the improved earnings do start coming in, the magnitude of any market rise may be blunted. The impact of inflation on bond prices is well documented. Rising inflation erodes the fixed payments that bondholders receive. The mere prospect of higher inflation can send bond prices tumbling because investors become unwilling to pay as much for a bond that is having the value of its future cash flows stripped away. This concept is at work when longer-term yields begin to climb as economic recovery becomes apparent. Investors are discounting the effect higher inflation will have on their fixed payments. Higher inflation also influences the price investors are willing to pay for a stock's earnings. A common barometer of stock valuation is the price-to-earnings ratio, or earnings multiple. It represents the price that investors are willing to pay for a dollar of earnings. This ratio is often higher in a low-inflation environment because future earnings are higher in real, or after-inflation, terms. Just as the accounting anemia that surrounded the Enron scandal made investors question how "real" profits are, inflation has a similarly distorting effect on future profits. As inflation rises, the real value of future earnings declines. As profits become more visible, making investors willing to pay more to acquire those profits, inflation could offset some of what investors are willing to pay. So although a return of corporate profit growth will fuel higher stock prices, these prices will reflect investors' expectations for the real value of those earnings. Higher inflation leads to a contraction in the P/E ratio, as some of investors' optimism is harnessed, and restraining to some extent rising stock prices. Inflation does not have the decimating impact on stocks that afflicts bonds. After all, bonds typically provide fixed payments while stocks provide a growing stream of earnings over time. But any surge in inflation would cloud the real value of future earnings and lead to a re-evaluation of the return investors are truly receiving. Greg McBride is a financial analyst for Bankrate.com. -- Posted: April 26, 2002
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