1. Money
You can opt-out at any time. Please refer to our privacy policy for contact information.

What Stock Investors Should know about Inflation

By

Businessman and stock report (Digital Enhancement)
Michael Goldman/ Taxi/ Getty Images
The stock market is being stalked by the “I” word and investors are showing their nerves. Inflation has The Federal Reserve Board running scared and we will all pay the price for it.

High energy prices, rising unit labor costs and pressure on supplies of key resources such as steel and cement (thanks to Hurricanes Katrina and Rita) are lining up like some ill-fated stars to guarantee the Fed will continue raising short-term interest rates.

High interest rates and companies raising prices don’t add up to an investment profile most investors enjoy. However, stocks are still a good hedge against inflation because, in theory, a company’s revenue and earnings should grow at the same rate as inflation over the time.

Global Market

While some companies can react to inflation by raising their prices, others who compete in a global market may find it difficult to stay competitive with foreign producers who don’t have to raise prices due to inflation.

More importantly, inflation robs investors (and everyone else) by raising prices with no corresponding increase in value. You pay more for less.

This means company’s financials are over-stated by inflation because the numbers (revenue and earnings) rise with the rate of inflation in addition to any added value generated by the company.

Earnings

When inflation declines, so do the inflated earnings and revenues. It is a tide that raises and lowers all the boats, but it still makes getting a clear picture of the true value difficult.

The Fed’s chief inflation-fighting tool is short-term interest rates. By making money more expensive to borrow, the Fed effectively removes some of the excess capital from the market.

Too much money chasing too few goods is one classic definition of inflation. Taking money out of the market slows the cycle of price increases.

There are two more meetings of the Open Market Committee (the body that sets rates) in 2005: Nov. 1 and Dec. 13.

Given the pressures mentioned earlier, you can take it to the bank that the Fed will keep raising rates at least through the end of the year.

Investments

Should you be concerned about inflation and your investments? If you have a substantial portion of your portfolio in fixed income securities, the answer is a definite yes.

Inflation erodes your purchasing power and retirees on fixed incomes suffer when their nest egg buys less each passing year. This is why financial advisers caution even retirees to keep some percentage of their assets in the stock market as a hedge against inflation.

The more cash or cash equivalents you hold, the worse inflation will punish you. A $100 under the mattress will only buy $96 worth of goods after a year of 4 percent inflation. Look for inflation-indexed products like the Treasury I Bonds and other products that offer a hedge against rising rates.

Conclusion

Investors should keep an eye on interest-rate sensitive stocks, since continued pressure by the Fed will keep rates moving up through the end of the year and probably into 2006.

©2014 About.com. All rights reserved.