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In early 2022, inflation has been nothing short of runaway, reaching levels not seen since the 1980s. In large part because of these inflationary readings, which reached 8.5% in March, the stock market has sold off dramatically, with the S&P 500 off to its worst start to a year since 1939. But what exactly is inflation, and what short- and long-term effects does it have on the market? Here’s a look at the interrelationship between the stock market and inflation and what you can do as an investor in response.
Why Is Inflation Damaging to the Stock Market?
The relationship is complicated, but one of the simplest reasons why inflation is damaging to the stock market is that it increases the cost of doing business.
Although “the stock market” is often seen as some type of monolithic entity, in reality, it’s simply a collection of real businesses, from the grocery store down the street to your favorite home improvement store.
As inflation raises the cost of everything from food to fuel to raw materials, it costs these businesses more money to provide the products you want and need.
Inflation also reduces your purchasing power as a consumer, meaning you may be less likely to buy as much as you normally might.
This combination of factors can reduce profits for businesses, and lower earnings for companies translates to lower prices in the stock market.
What Role Does the Fed Play?
One of the main jobs of the Federal Reserve is to keep inflation to a target rate of about 2%. The Fed believes that this is an appropriate level to help maintain a stable and healthy economy. With inflation shooting above 8%, the Fed is likely to take fairly dramatic steps throughout 2022 and perhaps even beyond to get that rate back under control.
The Fed’s primary tool in combating inflation is to raise interest rates. As rates go higher, economic activity tends to slow, which helps bring down an overheating inflation rate.
The problem for stock market investors is that high inflation combined with rising interest rates is something of a one-two punch for the economy. Rising inflation increases costs for both businesses and consumers, and rising interest rates, at least at first, do more of the same. Rising interest rates make everything from business loans to credit cards to auto loans and home mortgages more expensive. This “imperfect storm” can hurt stock market valuations even further.
The Stock Market Is a Forward-Looking Mechanism
Fortunately, the stock market is a forward-looking mechanism. Market pundits will often say that the stock market “looks forward” about six months, as investors place their bets on where the economy is headed rather than where it currently sits.
As the deadly combination of high inflation and rising interest rates typically doesn’t last too long, the stock market may begin recovering earlier than you might expect. Ultimately, the economy slows, inflation falls and the Fed can finally lower interest rates again; if investors wait until all that happens, it’s usually too late.
For Long-Term Investors, This May Be a Blessing
While short-term investors can take a beating during a cycle of rising inflation, the lowered stock market valuations can end up being a blessing for long-term investors.
As the age-old Wall Street axiom goes, you should “buy low and sell high.” When markets sell off, valuations can get dramatically low. While this is the hardest time to invest emotionally, it’s the best time to buy additional shares if you have a long-term time horizon.
Ultimately, markets recover over time, and whether that takes, weeks, months or years, it all works to your advantage as a long-term investor if prices rise in the end.
Steps To Take Now
While it’s easy to look at inflation and the stock market from an academic perspective, the reality is that investing can be an emotional endeavor. When you’re staring at big losses in your portfolio and no end in sight, it can be hard to “do the right thing.” But here are some steps you should write down in your own personal investment policy so you can take it out, look at it and follow it when things get bumpy.
Invest for the Long Term
Taking large losses while investing for the short term can be devastating. Remember that stock market investing is intended for money that you won’t need for at least five years. Investing for the long term not only protects you from taking big short-term losses, but it can also give you the peace of mind that your portfolio has time to recover.
Don’t Watch the Stock Market Every Day
If you’re really a long-term investor, this one shouldn’t be too tough to follow. Take a look at any long-term chart of the stock market. Notice that the longer the time frame you use, the less volatile the stock market seems to be. On a long-term basis, the quick, day-to-day moves of a volatile market become smooth, and the chart moves consistently and steadily higher. Subjecting yourself to the emotional trauma of watching big, short-term sell-offs will only make it more likely that you will stray from your long-term investment strategy.
Stick to Your Investment Strategy
Just because the market is down doesn’t mean that you should stop your regular monthly investments, or try to make money with a quick trade. If you’re a long-term investor, nothing has changed, even if the market is down 20% or 30%. In fact, these types of selloffs are fairly “normal” over the long run, and you will experience them more than once over a long investing career. As the market is acting normally, you should also, by continuing your long-term investment plan.
Consider Adding Value Stocks
If you’re convinced inflation is here to stay for a long stretch and your portfolio is overweighted in aggressive, growth-oriented names, consider adding some value stocks. Value stocks tend to outperform growth stocks in periods of rising inflation and/or interest rates, and they are by nature more defensive. You can find value stocks by looking for slow, consistent earnings growers that typically pay dividends and have been around for decades or more, such as big pharmaceutical companies or consumer products companies.
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