This is not true. Apart from perhaps an inflation of asset values which may play a part in some shares that tend to trade at low price-to-book ratios, shares generally go up as a result of retained profits, not inflation.

Ben Graham argues that the only effect that pushes up stock prices (apart from interest rates) is corporate profitability. Share prices go up because some profits are retained, not every last cent of profit is paid as a dividend. Leeb goes a little further and explains the effect of inflation on profits, arguing that as a rule inflation is bad for corporate profits.

If shares have in the past consistently outperformed inflation it is because average sustainable return on equity (ROE) has been higher than the average rate of inflation. In times of very high inflation stocks tend to give poor "real returns". Thus it can be argued that property and shares are both valid investments offering excellent diversification benefits.

The diversification benefit is not just the Modern Portfolio Theory view of uncorrelated assets giving rise to a lower volatility of returns, rather the diversification comes from the drastic difference in performance of shares and property compared with respect to inflation. Property will as a rule give higher returns than shares in times of very high inflation, shares will give better returns at times when inflation is more moderate.

For those that want property exposure but don't want to go to the trouble of investing directly there are many listed property trusts and also managed property trusts that invest in these listed property trusts (an example being the Vanguard Property Securities Index Fund, as well as various property trusts such as those offered by AMP, AXA, Colonial First State and Credit Suisse).

Ben Graham on stocks and inflation

The reader will object that in the end our calculations make no allowance for an increase in common stock earnings and values to result from our projected 3% annual inflation. Our justification is the absence of any sign that the inflation of a comparable amount in the past has had any direct effect on reported per-share earnings. The cold figures demonstrate that all the large gain in the earnings of the DJIA unit in the past 20 years was due to a proportionately large growth of invested capital coming from reinvested profits. If inflation had operated as a separate favourable factor, its effect would have been to increase the "value" of previously existing capital; this in turn should increase the rate of earnings on such old capital and therefore on the old and new capital combined. But nothing of the kind nothing of the kind actually happened in the past 20 years, during which the wholesale price level has advanced nearly 40%. (Business earnings should be influenced more by wholesale prices than by "consumer prices.") The only way that inflation can add to common stock values is by raising the rates of earnings on capital investment. On the basis of the past record this has not been the case.

Stephen Leeb on stocks and inflation

As I said, one of the factors that alters the course of interest rates is inflation. Interest rates affect market valuations but in order to really get the hang of things you should look at what causes interest rate changes.

Whether the cause of falling prices is interest rate changes, or inflation itself, it hardly matters except to economists. The fact is that market returns are negatively correlated to both inflation and interest rates, though this would be expected as they are intertwined.

The following information comes from Market Timing For the Nineties by Stephen Leeb and Roger S. Conrad (1993), this is an interesting book that contains a fair deal of data and tables of this sort, and is one of the main sources of inspiration for this, and most of the remaining articles in this section of the FAQ. The data relates to American inflation rates and returns on American markets. I haven't come across this sort of information for the Australian market as yet, but I'll go out on a limb and assume that relationships that apply to American securities will also hold true in this country, at least to an extent.

Leeb claims that the history of the stock market is a history of inflation. He characterises four levels of inflation:

CPI vs market returns

The "GDP deflater" is a figure released along with the publication of the GDP each quarter. This figure indicates what proportion of the GDP change arose simple from price increases, and as it involves many thousands of estimates is easily the best and most comprehensive measure of inflation. The biggest flaw though is that it is such a complicated piece of information that it is frequently substantially revised many months after release, and the lag between the eventual final released figure is even worse than the CPI. It gives beautiful correlations to historical returns but for an investor in the trenches it is less useful.

A more applicable index, and one that is available on a more regular basis is the "Producer Price Index" (PPI). Unlike the CPI, which deals with retail goods, the PPI concentrates on semi-finished goods. As a result, it picks up prices changes somewhat earlier than the CPI does.

There are various ways of measuring the PPI, but the "all-commodity producer price index" may be the best, this includes the cost of raw materials as well as semi-finished industrial basic goods, so it tends to show inflation trends far more quickly than the CPI ever could.

Based on 75 years of data, this is how the all-commodity producer price index correlates with the performance of the Standard and Poors 400 stock index over the following 12 months:

All-commodity producer price index vs subsequent stock returns

Leeb suggests that investors use a five year average of the annual percentage increases and decreases in the PPI, as it provides a smoother figure to use than annual figures, smoothing out annual fluctuations and providing a figure perhaps more useful to longer term investors.

CPI vs PPI and stock returns

If you subtract producer prices from consumer prices, you get a measure that amounts to an approximation of corporate profit margins. Leeb found that when the CPI was increasing faster than the PPI stocks did extremely well, but they did poorly when PPI increased more quickly than CPI: