O'Shaughnessy on How Inflation Impacts Stocks, Bonds

Given the huge growth in monetary supply that the Federal Reserve has overseen in an effort to combat the financial crisis and Great Recession, many top strategists — including Warren Buffett, John Paulson, and Bill Gross — have said that they expect significant inflation to hit the U.S. at some point. And if that’s the case, according to new research from James O’Shaughnessy, active stock selection strategies are the place for investors to be.

“If the current Fed monetary expansion leads to double-digit inflation, expect bonds to be crushed and stock indexes to do poorly as well,” O’Shaughnessy writes in a new research paper available through his firm’s web site. ” The only hope … might be from active stock selection strategies.”

In the paper, O’Shaughnessy looks at how stocks have performed in five different inflationary climates since 1900: severe inflation (over 10% per year); high inflation (4.4% to 10%); Fed target to moderate inflation (1.6% to 4.4%); low inflation (0 to 1.6%); and deflation.

Among his findings:

During times of severe inflation, U.S. bonds have produced an average real return of -12.5% per year; stocks have fared much better, though they still have lost 6.7% per year (all returns referenced here and below are real returns);

The best decile of stocks based on six-month relative strength has returned 9.3% per year during severe inflationary climates, however; those in the best decile according to shareholder yield have kept losses to 4.9% annually;
In high inflation climates, bonds have lost 3.1% per year, while stocks have gained 1.9%;
In high inflation climates, the top decile of strong momentum stocks has gained 4.0% on average; the top decile based on shareholder yield has gained 7.7%.

In all of the other inflationary climates, stocks have outperformed bonds, and high-momentum and high-shareholder yield stocks have outperformed the broader market. O’Shaughnessy’s bottom line: “For those investors worried about the consequences of recent government and Federal Reserve actions, now would be a very appropriate time to position portfolios in equity strategies which focus on high yields and strong momentum.”