The Recession

Why the Stock Market is Safe Bet for Future

| by The Heartland Institute

Given the current ups and downs in the market (mostly downs), can we still rely on the stock market as a hedge against the future? Heartland policy advisor, John Skorburg, looks at data from the great depression to answer this question.

His answer is, yes, for the long-term – a good mutual fund of stocks should outpace inflation. Here’s the rationale:

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Whenever the stock market of an individual country moves up or down on a daily/weekly/monthly basis, various media reporters try to explain such movements either up or down with specific reasons such as: the market was up today because oil prices decreased or the market was down today causing gold prices to soar.

But what does data from the great depression tell us?

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The survey of the literature linking inflation with stocks, begins essentially with Irving Fisher (1930), where Fisher reveals that inflation has a positive impact on the stock market.

Using the infamous Fisher Equation (Nominal Interest Rate = Real Interest Rate + Inflation Expectations), Fisher conjectures that stocks indeed are a hedge against inflation. Simply, the Fisher equation restated is: i = r + ð where i = the nominal interest rate, r = the real interest rate, and ð = the expected inflation rate.

Fisher used this equation to show that such an analysis applies to stock returns too. In short, Fisher states that the long-run relationship between inflation and the stock market is positive and that stocks are indeed a long-term hedge against inflation.

Follow up:

This initial research was published at a shaky time in American economic history. As such, Herald (in 1934) revisited Fisher and a very preliminary stock/inflation study by Edgar Smith (1923) noting that the stock market crash of 1929 had “shaken the common stock theory” as an inflation hedge, but it still stood on “a firm base” and had “not been destroyed.”

Future research in this area will help to determine if key commodity prices such as oil and gold have a specific relationship to stock returns and if stocks continue to be an inflation hedge in the long-run, even if short-term analysis continues to reveal that stock returns are only a partial inflation hedge. Still, after 75 years, the Fisher effect appears to hold under many specific circumstances.

In short, the stock market, in the long-term, still looks like a good bet!