Certain stock market investors are secretly hoping that inflation heats up in coming months.
I bet you thought I’m referring to gold bugs. But I’m instead talking about value investors, since value stocks historically have been an even better inflation hedge than gold.
The reason value investors are keeping their hopes of higher inflation secret is that most other investors dread higher inflation, as I pointed out in a column last week. It would be unseemly to get too much pleasure from others’ pain. But value investors are keenly aware that the value-over-growth premium tends to rise when inflation accelerates.
A decade in the making
And that’s why value investors are particularly hopeful right now. After a decade in which inflation has been unexpectedly low, inflation expectations are beginning to rise — especially so in recent weeks. Compared to an increase in the Consumer Price Index over the last 12 months of only 1.4%, the bond market is currently betting that CPI will rise at a 2.3% annualized rate over the next five years (as judged by the five-year breakeven inflation rate).
Inflation is good for the value premium because growth stocks are those for which a disproportionate share of their valuation comes from future years’ earnings. So as inflation heats up, the present value of their futures earnings can decline precipitously. Value stocks are at the opposite end of the spectrum, with a relatively greater proportion of their valuation derived from current earnings. So they are relatively immune to higher inflation.
To illustrate, consider a biotech company that has no current year earnings and whose stock price is entirely a function of future years’ earning potential. It would be the ultimate growth stock. So when inflation drops, such as it did a year ago as the economy was put in a medically induced coma, theory predicts that its valuation will shoot up relative to value stocks. Sure enough, over the last year the SPDR Biotech ETF XBI, -3.00% has beaten the iShares S&P 500 Value ETF IVE, +0.66% by an incredible 57 percentage points.
This is just one data point. But the general pattern is borne out historically as well. Since 1926, as you can see from the accompanying chart at the top of this column, value stocks have beaten growth stocks by the most when inflation is higher. Notice furthermore the monotonic relationship between lower inflation rates and a smaller value premium.
Expected inflation in coming years falls in the category that’s associated with a value premium of 8%, in contrast to a premium that’s barely positive when inflation is between 0% and 2%. No wonder that value investors are getting excited.
One sign of that excitement: The performance since last November of a package of value stocks that were highly recommended by the value-oriented newsletters my firm monitors. On average since that column was published, those stocks have produced a gain of 35.7% versus 10.9% for the S&P 500 and 9.9% for the S&P 500 Growth ETF IVW, -1.94%.
Ten days ago I presented an updated list of these newsletters’ most-recommended stocks. Since then they have outperformed the S&P 500 by a margin of 2.1% to minus 0.7%.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.