The topic of inflation tends to be a tool used by both sides of the debate about stock market performance. It's argued that because corporations can pass on rising prices of raw goods to consumers, earnings will keep pace with inflation, so equities are a good hedge against inflation. It's also argued that because the 1970's was a terrible decade to own stocks, very high rates of inflation must be bad for equities. As in many discussions surrounding financial market topics, there is some truth in each of these arguments. But the full story tends not to lend itself to such broad generalizations. As John Hussman observed a few weeks ago, stocks can benefit from inflation once it is widely anticipated and well-reflected in valuations, but otherwise, stocks are not a very good inflation hedge in periods when inflation is rising.
Maybe one of the most underrated risks regarding inflation is the speed at which it is rising, even if that increase is off of a low base. It's not high levels of inflation that precede important stock market declines, but instead how rapidly inflation is rising relative to its recent trend. And when you mix an overvalued market with rapidly rising inflation, bad outcomes tend to follow.
The start of a contraction in valuation multiples has historically come long before high levels of inflation. Rather, it's inflation rising faster than its recent trend - sparking concerns of higher longer-term inflation - that increases risk aversion among investors. When these periods occur alongside high P/E ratios, the contraction in multiples has usually been substantial. Ben Bernanke recently told Congress that he is confident that the recent rise in the rate of inflation will be temporary, and that inflation expectations are unlikely to become unhinged. Stock investors must be able to share that belief and that forecast, because a change in longer-term inflation expectations – even from a low base – would increase stock market risks importantly.