Common Stocks And Inflation

We often hear the statement that "common stocks should be bought as a hedge against inflation." From the viewpoint of cold statistics this may be shown to be true, and a very strong case has been made regarding the merits of common stocks. However, this does not tell the full story, for there are at least two important doubts which may be cast upon this rosy picture.

The first doubt, or shortcoming, concerns the behavior of the stock market. It is true that the market may show a sustained advance, but it does not follow that all stocks participate in this advance to the same degree! For example, suppose that an investor had picked five major chemical stocks at the beginning of the currently long-sustained high market, say in 1940.

He would have done exceedingly well, having had a very comfortable income and considerable equity appreciation (gain in invested capital), because these stocks have been outstanding in their market performance. On the other hand, suppose he had invested in such things as meat packing, textiles, and farm equipment; his appreciation would have been far less and, in some instances, he might even have suffered losses!

In other words, we have here a problem of careful and judicious selection, and it is only the best-qualified investor who may be right all the time-and even then, he is not always sure he will be 100 per cent right!

The second element of doubt concerns our blithe assumption that inflationary trends will continue forever. This is not necessarily so, since past experience has shown that inflation is eventually followed by a certain amount of deflation.

When this takes place, the bondholder will again be on top of the pile, and the common-stock investor will find his values have shrunk considerably. Should the latter be forced to sell in a period of falling prices, he may be required to accept severe losses. This means that common stocks may be a hedge against long-term inflation, but that the other side of the story is deflation, at which time the bondholder may be actually much better off; in addition, deflation actually restores the normal dollar, from which the bondholder will most assuredly have the most benefit.

The question of the value of money is a continuous one and the haunting figure of inflation constantly appears in the background. Will inflationary trends continue? Will they be arrested only temporarily? Will the next decade or two see the return of deflation, rather than an increase of inflation? Even a crystal ball will not answer these and similar questions.

Must we reckon with inflation in an investment program? Most certainly we must! Just as fixed-dollar investments provide against deflation and just as investments in common stocks provide against inflation, so we must try to diversify our funds so as to strike a reasonable medium. More and more the merits of common stocks are being seen in a new light; less and less are we making our comparisons with 1929; indeed, present-day analysts and investment counselors, bankers and brokers, have agreed that the placement of some funds in common stocks is both necessary and desirable.