Would inflation be good for stocks?

With the monetary and fiscal spigots open wide, some investors say equities are a good place to be. But David Einhorn of Greenlight Capital has warned that inflation could compress price-to-earnings multiples. A look back to history suggests his fears are warranted.

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The Federal Reserve has lowered rates to virtually zero and expanded its balance sheet significantly, stuffing banks with excess reserves that are available to lend. If the market picks up, banks will find themselves surrounded by creditworthy borrowers again and excess reserves could quickly flow into the real economy, increasing inflation.

In the meantime, many analysts argue that the government is likely to keep printing money to finance runaway fiscal deficits and large unfunded obligations for Medicare and Social Security, increasing inflation.

The Fed will tell you that deflation is the primary risk facing the economy as the private sector continues to de-lever. And inflation is hardly guaranteed. There’s still time for the Obama administration to get America’s fiscal house in order and the Fed can choose to tighten monetary policy. Highly unlikely both, but nevertheless possible.

If inflation is in the cards, why might that be bad for stocks? One reason is that investors will pay less for future earnings.

Historically, according to Howard Silverblatt of Standard & Poor’s, investors have valued stocks of the S&P 500 at about 17 times earnings. If a company stands to earn a dollar per share in a given year then investors will tend to pay $17 for a share of its stock.

But if you add inflation to the mix, future earnings lose their purchasing power, which means investors won’t pay as much for them.

Einhorn, at the Value Investing Congress on Monday, said that if we wind up with significant inflation, distant earnings will be discounted at higher rates, meaning “P/E ratios will collapse.”

We see this relationship in action if we compare the average P/E multiple of the S&P 500 with inflation as measured by the Consumer Price Index. In the 1960s, when inflation was low, P/E multiples were high. In the 1970s, when inflation was high, P/E multiples were low. After Paul Volcker beat back inflation in the early 1980s, P/E multiples began a two-decade expansion.

To be sure, investors use expected inflation rates when discounting future earnings. That said, when building their models they tend to extrapolate the future based on the present.

Depending on its relative impact on revenues and costs, inflation may or may not be good for company earnings, but it will certainly shrink the multiple investors are willing to pay for them.