I wrote the following in April of 2020, early in the pandemic:
It seems bizarre to worry about inflation during the sharpest, most severe economic contraction of our lifetimes.
But the sheer amount of government spending and monetary policy being instituted by the Federal Reserve means that this is something that is on people’s minds as a potential risk in the not-too-distant future. The “worry” is the economy could potentially overheat through a combination of demand and government spending once the virus is contained.
My initial study on this is that if we get inflation out of all this spending it’s a good thing – it means we beat the virus and things go back to normal (if there is such a thing).
I’m not going to take a win lap here because I certainly didn’t expect inflation to rise to around 8%. I wasn’t expecting so many supply chain issues stemming largely from consumer demand.
And that piece was not so much a macro call as it was trying to understand why value stocks outperformed growth stocks so badly in the years since the pandemic.
My conclusion was that value stocks once again required higher inflation to outperform. Here is the scene:
While not a perfect relationship, price has tended to outperform during decades with inflation above average and to perform poorly during decades with low inflation. This was my original explanation on the logic behind it:
Think of growth stocks like a bond. The reason inflation is such a big risk for bondholders is because the purchasing power of your fixed rate income payment is depleted by inflation over time.
The same is true of future growth in revenue or the promised future in profits of growth stocks. Value stocks already have cash flows that are likely to decrease in the future. Thus, higher interest rates should hurt stocks with less value than growth stocks because the higher hurdle rate doesn’t make future growth worth as much.
Inflation has been rising for over a year now so let’s test this theory.
Here are the returns for DFA Small and Large Cap Value Fund1 Compared to market and growth stocks from the beginning of 2021 to the end of Monday:
Value stocks have outperformed by a healthy clip during this inflationary environment. So far, so good.
In the same excerpt I also saw this dynamic in foreign markets:
Even for international stocks, the value has tended to outperform when inflation is high.
Look and behold, international value stocks have outperformed as well:
Obviously, it would be foolish to assume that inflation is the only factor driving value stocks or growth stocks. Inflation plays a role but when inflation is also operating at a high level the nominal growth is higher.
And sometimes the value is good because the growth appraisal becomes too fuzzy with reality.
I’m not smart enough to predict whether value stocks will continue to outperform because I can’t predict the future path of inflation (and I’m not sure anyone else can).
But it is a good reminder about the importance of diversifying your portfolio in a variety of economic environments.
This chart from Ray Dalio’s The All Weather Story has always been with me since I read it several years ago:
The idea here is to tie together investments that operate under different economic systems because we don’t know when or why the economic environment will change.
No one was predicting massive inflation/economic growth in 2019, but that’s what we are living in at the moment.
We haven’t really faced a rising inflation/rising growth economy in a long time.
Value stocks have been lagging for some time now but perhaps they need the right environment to shine.
I’m not saying that value investing will continue to outperform. I really don’t know.
I don’t know if high inflation is here to stay.
I don’t know how much of an inflationary story there is for both value and growth stocks now.
I don’t know if the Fed will be able to control inflation.
I know that building a sustainable portfolio requires a diversification of strategies that can work well under many market and economic environments.
Further reading:
why did the price die
1Full Disclosure: My firm uses DFA funds for some client portfolios and I myself own some of these funds.
