It is well known that stocks and bonds do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market’s problems in this period are still imperfectly understood.

The problems of bondholders in an era of inflation is not a mystery. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner.

Stocks on the other hand was long assumed that is is something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might.

And why didn’t it turn out that way? The main reason, is that stocks, in economic substance, are really very similar to bonds.

It may be difficult to understand this belief as it may be too eccentric to  many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.

To better understand this, you must think of those companies but as productive enterprises not as listed stocks. Assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12% too. And because the return has been so consistent, it seems reasonable to think of it as an “equity coupon.”

In the real world, of course, investors in stocks don’t just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity coupon but reduces the investor’s portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to the productivity of enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.


It is also true that in the real world investors in stocks don’t usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they’ve had to pay more than book, and when that happens there is further pressure on that 12%. Meanwhile, let’s focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return just like those who buy bonds.

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.

Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12%, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase. So, score one for the bond form. Bond coupons eventually will be renegotiated; equity “coupons” won’t. It is true, of course, that for a long time a 12% coupon did not appear in need of a whole lot of correction.

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