Stocks and Inflation
by Adam Hamilton
August 26, 2005

Inflation, a pernicious stealth tax on purchasing power surreptitiously levied by immoral governments, is one of the greatest persistent obstacles to serious wealth generation.

By creating fiat money out of thin air and spending it today, governments increase the amount of money in circulation. The larger the money supply grows, the more dollars bid on and compete for goods and services driving up general prices. These rising prices reduce the purchasing power of investors' scarce capital, effectively expropriating it through a dishonorable "tax" that not 1 in 50 people truly understand.

Inflationary policies increasing monetary growth are tax increases, no different in ultimate effect than directly raising marginal income tax rates. But since so few people, including sophisticated investors, really grasp this, governments often prefer inflation to politically unpalatable direct tax increases.

Somewhat ironically, this relentless monetary inflation hits the poor the hardest, as rising general prices have the largest proportionate effect on those with the lowest incomes. This strikes me as irony-laden because governments across the world actively subsidize the poor in order to bribe them for votes at election time. If these poor folks really understood just how regressive inflationary taxation truly is, they would probably revolt.

Thankfully we investors are not burdened with poverty. The ultimate source of investment capital is savings, consuming less than one earns. And since we investors have lived under our means long enough to save capital to invest, we are obviously not living hand-to-mouth where any rise in general prices would crush us.

Nevertheless, inflation is still a dire threat to our hard-earned investment capital. Over long-term secular time horizons, the inflationary erosion of purchasing power can radically alter our ultimate returns. It does an investor no good to earn 10% when general prices also rise 10%, as his net gain in purchasing power is zero. We invest in order to earn greater purchasing power to increase our standard of living, not to merely see nominal numbers grow.

Interestingly, the groups of investors that seem the most savvy in considering real (inflation-adjusted) returns instead of the usual nominal ones are the contrarians investing in commodities. As I discussed last week, commodities investors often know exactly where key commodities like gold or oil traded in real terms over the past half century. Studies of real commodities price histories are fairly common in contrarian circles.

But sadly mainstream stock investors are seldom if ever exposed to inflation-adjusted studies on the stock markets. Whenever Wall Street talks about secular gains, like in the Great Bull Market from 1982 to 2000, nominal stock-index numbers are used. This serves Wall Street's interests well by seriously overstating the actual purchasing-power gains won by past investors, but it does a great disservice to today's investors.

If an investor earns 100% over years but general price levels rise 50% over this same time, half of the investor's perceived gain is nothing but an illusion. Nominal numbers over long timespans are meaningless as investors seek to multiply capital in order to ultimately spend it on actual goods and services some day. True gains are only relevant in terms of their impact on raw purchasing power. Stock investors really need to take this to heart.

In order to analyze the impact of inflation on stock investors, we did some research work on the mighty S&P 500 this week. The S&P 500, of course, is the flagship US stock index that represents the preeminent publicly traded corporations in America. It is the best proxy for the US stock markets as a whole and it yields the benchmark returns by which all other investments and even portfolio managers are measured.

Using monthly data since 1950, we overlaid the usual nominal S&P 500 with a real S&P 500 adjusted for inflation. The US Consumer Price Index was used for computing the monthly inflation adjustments, which is extremely conservative.

The CPI is intentionally lowballed to understate inflation for political reasons since inflationary expectations are so dangerous for the financial markets. Indeed even Alan Greenspan has said many times that the Fed fears the rise of inflationary expectations even more than inflation itself since the mere expectation of inflation radically alters global capital flows and buying patterns in stocks and bonds.

In addition, non-discretionary government expenses like pensions are directly tied to CPI inflation, so the lower the numbers conjured up the more cash Washington has for discretionary programs it would rather pursue. Higher reported inflation would lead to higher interest rates too, forcing the US Treasury to pay much more to finance its gargantuan debt. True inflation is raw money supply growth, not the heavily manipulated CPI.

So as you drink in this chart and its sobering implications, please realize that these numbers are the most conservative possible estimate of inflation that your ever-benevolent government wants you to believe. If broad M3 money growth was used to measure inflation as it ought to be rather than the controlled CPI, the results below would be far, far worse. CPI inflation truly is the best-case scenario for investors.

The blue line below is the usual nominal S&P 500 and the red line represents the CPI-adjusted real S&P 500, in constant 2005 dollars. At various major long-term highs and lows the actual index levels are noted, and the nominal (blue) and real (red) returns between these interim extremes are computed. Yellow numbers under these returns show the ratio between real and nominal gains. Ratios under 1.00 indicate that actual real returns were smaller than nominal S&P 500 gains.

The net impact of even conservative CPI inflation on long-term stock investors in the last half century has been staggering. Inflation matters, in a monumental way, for stock investors working hard trying to multiply their scarce and precious capital. Only fools ignore the long-term effects of inflation on investments.


One of Wall Street's greatest selling points, which is unfortunately a myth, is that stocks always do well over any long-term span of time. In reality the precise endpoints bracketing a particular long-term timespan are crucial for determining long-term investment success. And the ravaging effects of inflation act to magnify the paramount importance of exquisite buy and sell timing.

Note on the blue line above how the S&P 500 went from 108 in the late 1960s to 107 in the early 1980s for a small 1% loss. That is bad enough, to not earn any money over more than a decade, but if you look at the same slice of time in the red inflation-adjusted data, investors actually lost nearly two-thirds of their purchasing power over this same period! Real losses ran 54x the nominal losses during the last secular bear market a few decades ago.

This illustrates one of the key points of long-term real returns. When stock prices are flat or declining, inflating money supplies accelerate the real losses borne by investors. Somewhat frighteningly, we have already witnessed this in the first downleg of the latest secular bear since 2000. Real losses were already running 1.05x the nominal losses and I suspect this multiplier will only grow as the years march on.

Speaking of years, careful observers will note that the durations marked in gray above for major secular bull and bear markets differ somewhat from those periods recently discussed in Long Valuation Waves 2. The reason is the monthly data used here versus the daily data in my long wave studies. Since CPI data is only available monthly, it makes sense to use monthly stock-index closes as well for this analysis. Actual monthly tops and bottoms can differ significantly in time from when the absolute intra-month daily tops and bottoms are achieved.

And inflation doesn't just accelerate real losses during secular bears, it retards real gains investors earn during secular bulls. Both secular bulls rendered above clearly drive home this key point. In the 1950s and 1960s, nominal gains ran 536%. But in real terms investors only earned 322% over nearly two decades, or 0.60x the headline gains. While 322% is not trivial, it is vastly inferior to 536%.

And during the greatest bull market in US history, in the 1980s and 1990s, nominal gains rocketed up a staggering 1317% higher. But after inflation was accounted for, investors only earned about half that, 0.53x or 700%, in terms of raw purchasing power. This reveals the unpleasant truth that fully half of the bull-market gains of legend in the last couple decades were illusory, solely driven by Washington and the Fed relentlessly expanding money supplies and driving up general prices.

Now at this point it wouldn't surprise me if stock investors are thinking, "So what? A 700% increase in my purchasing power is excellent and beyond ridicule." But they have to realize that this 18-year period of 700% real gains is a major anomaly. Not only is it rare, but investors would have had to buy at exactly the 1982 low and sell at exactly the 2000 high. Perfect timing is not very likely in reality.

What if, instead of buying in 1982 at a major low where everyone hated stocks, investors had bought at a major real high in the late 1960s when everyone loved stocks? In November 1968 the real S&P 500 closed at 599 on a monthly basis. It would not hit this level again until December 1992 and not go materially higher until March 1995. Thus, investors buying at the wrong time during the late 1960s top would have waited 26.3 years before they earned even one additional percent of purchasing power! Ouch.

Such a quarter-century drought devoid of any real gains is absolutely catastrophic. If an average investor starts investing at 25 and retires to live off investments at 65, he only has four decades in which to earn his fortune. Losing 26 years out of these 40 due to buying at the wrong time in the Long Valuation Waves and being ravaged by inflation would utterly scuttle any chance of recovery.

While it is certainly fascinating that the effects of inflation accelerate losses in secular bears and retard gains in secular bulls, the longer term that one's perspective becomes the more the ravages of inflation become evident. The popular Wall Street assertion that stocks always do well in the long term, when adjusted for declines in purchasing power due to monetary inflation, becomes a pale shadow of its former self.

In the chart above one truly huge timespan is delineated. It runs from 1950 to 2000. Now please realize that the US stock markets made a major secular bottom in 1949 and a major top in 2000, so out of any times to buy and sell since World War 2 these are the most optimal by far. There are no other two interim extremes that would yield higher gains. In this perfect best-case scenario, the S&P 500 rose by a massive 8801% over a half century!

These are awesome gains, but once again they are nominal, not adjusted for purchasing-power declines. If we take the inflation-adjusted S&P 500 in constant 2005 dollars, the gain is gutted to merely 1111%. Over the past half century from the absolute best-case moments in time to buy and sell for the long term, fully 7/8th of the gains investors could have reaped are illusory. These are wiped out by rising inflation decreasing purchasing power.

Now in order to earn 8801% over a little under 51 years, an investor would have to earn 9.25% a year on average in nominal terms. But this same 8801% corresponds with only 1111% in real terms, which works out to an average of 4.87% a year over a half century. Thus inflation wiped out half of the best possible annual gains in the last half century or nearly 7/8th of the final compounded return. Inflation has a huge impact.

All long-term investors, regardless of what they choose to invest in, must consider the relentless impact of inflation. In this stock market case 4.87% real compounded annually is certainly not bad at all, but it is over the most optimal period possible and is a far cry from 9.25% a year nominal. And this inflation obviously doesn't just affect bonds and commodities as many folks believe, but stocks and even real estate.

The bubblicious real-estate industry today makes a big deal out of quoting nominal gains in houses over long-term periods often running several years to several decades. While inflation has a minor effect over several years, when you get into decades its effect is huge. Just as in stocks, the majority of any gains in a house from 1950 to 2000 are likely eaten up by inflation with true real gains only comprising a modest fraction.

In order to increase their real wealth, investors must seek gains that handily outpace inflation in order to multiply their purchasing power over time. Stocks, bonds, real estate, and commodities can all do this easily if they are purchased near the bottoms of their long cycles. But if they are purchased near the tops of their long cycles, they could face decades with no nominal returns and massive real losses.

As I outlined recently, unfortunately stocks are still near the 2000 top of their long cycles. It usually takes 17 years or so for stock markets to run from their secular peaks to their secular troughs, so unfortunately we are probably only a third or so into this current secular bear. Investors who buy stocks today and want to hold for a decade or more likely face flat markets at best.

Flat markets may not seem like the end of the world, but when the Fed's relentless fiat inflation is factored in it can lead to massive real losses over timespans exceeding a decade. From the late 1960s to the early 1980s the S&P 500 was unchanged nominally. But after inflation is considered these same investors lost nearly 2/3rd of their purchasing power just for being invested in stocks at the wrong time. Investors face similar peril today due to our similar waning phase in the long cycles.

No investment, including stocks, is immune from the scourge of inflation. Rising money supplies raise general prices across the board simultaneously making each dollar an investor earns worth less in terms of the actual goods and services it can buy. All long-term returns, regardless of the market of origin, must be considered in real terms to be honest and relevant.

The only way to beat inflation is to ride the perpetual bull. There is always a bull market somewhere. When stock cycles are in their rising phase as from 1982 to 2000, investors should be heavily long stocks where they can reap excellent real returns. That particular period yielded awesome real returns running 11.4% a year on average. But from 1966 to 1982, a bear phase, investors would have lost 7.2% real annually in the exact same stock markets.

Thankfully when stocks are in the bearish phase of their long cycles commodities are in their own bullish phase, and vice versa. The commodities markets tend to move exactly out of phase with stocks. Commodities were topping in the early 1980s when stocks were bottoming and they were bottoming in 2000 when stocks were topping. Now today as stocks grind lower commodities are already marching higher in their greatest bull market in decades.

If you are a long-term stock investor who hasn't yet been exposed to these ideas, I understand that they can seem pretty radical. If you do want to understand, I have written several essays just for you. Check out "Long Valuation Waves 2" and "Curse of the Trading Range 2" to see why stocks likely face very tough sailing ahead for the next decade or more. The offsetting bull in commodities is outlined in "CRB 300 Breakout!"

At Zeal we are trying to ride these secular trends and are heavily deploying capital in this young commodities bull. Commodities are vastly more likely to yield returns far exceeding inflation than the receding stock markets at this point in history. As we find promising new commodities-related companies to buy, we profile and recommend them in our acclaimed Zeal Intelligence monthly newsletter. Please subscribe today!

The bottom line is inflation does matter for all long-term investors, regardless of which particular market they choose to invest in. When individual markets are in secular bear phases inflation accelerates real losses, and when they are in secular bull phases inflation retards real gains.

In order to stay ahead of inflation and actually multiply their purchasing power, investors can't stay in one market forever but must periodically switch from a receding market to an ascending one. Rather than wait out a bear in stocks that inflation will make much worse for investors, why not instead invest in a commodities bull where gains will probably far outstrip inflation in the years ahead?

When central banks and governments conspire to expropriate wealth from investors via their inflationary stealth taxes, the only way to come out ahead in this game is to always be invested in whichever market happens to be in a secular bull.

Talk Back

Adam Hamilton, CPA

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit for more information, for a free sample, and to subscribe.

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