Monday Morning: Productivity growth could still reward investors

The recent drop in the nation’s productivity caused a mild stir among market analysts for two reasons. First, low productivity means lower earnings, and lower projected earnings, all other things being equal, means lower stock prices. And second, lower productivity is likely to mean higher inflation.

In fact, there have been some indications that inflation may be lurking in the bushes, preparing to spring forth and attack the economy. Most significantly, despite the weak employment scene, labor costs have been sneaking up.

But doesn’t higher inflation mean higher stock prices? Aren’t stocks a good hedge against inflation? That is the conventional wisdom.

But the answer is complicated.

Steve Leuthold of the Leuthold Group in Minneapolis did a thorough examination, during the burst of inflation from 1973 to 1981, of the relationship between stock returns and inflation. Published as “The Myths of Inflation and Investing,” the study examined inflation and stock returns over 108 years.

During periods of extraordinary inflation, with inflation rates greater than 8% per year, stock prices declined by 1.4% a year on a compound annual basis, Mr. Leuthold found.

During periods of relatively high inflation – 4% to 7% per year – they declined by 5.8% per year.

During moderate inflation, 2% to 3% per year, just what we’ve enjoyed in the past 10 years, stocks appreciated at a compound annual rate of 7.1%. When inflation was 1% or less, stocks appreciated at 8% per year. During mild deflation, stock prices fell 2% to 4% per year.

a bad influence

The returns during moderate inflation would no doubt be revised upward given the returns of the past 15 years, but the general point remains unchanged: Inflation is generally not good for stocks.

The market returns for any particular year seem to be greatly affected by investors’ perceptions of inflation trends. If investors believe inflation is increasing, stock prices drop. If they believe inflation is stabilizing or declining, stock prices rise.

For example, the inflation rate surged to 17% in 1917, from 8% in 1916, and the market dropped 30.7% in 1917. The inflation rate was 18% in 1918 and 15% in 1919, and the market gained 16.1% and 13.1%, respectively. The inflation rate edged up to 16% in 1920, and the market fell 23%.

Likewise, in 1973 the inflation rate was 8.8%, up from 3.4% in 1972, and the market dropped 14.7%. In 1974, inflation increased to 12.2%, and the market plunged 26.5%. When inflation subsided to 7% in 1975, the market surged 37.2%.

temporary lull

For the whole 1973-82 period, when inflation averaged 8.7%, according to Ibbotson Associates in Chicago, the stock market returned only 5.2% compounded annually. Long-term government bonds returned 5.8%. Investors lost purchasing power in both asset classes.

So inflation is not good for investors. Luckily, increasing productivity can help hold down inflation, and the recent drop in productivity, if it is real, probably will be only temporary.

As Bruce Steinberg, chief economist at Merrill Lynch & Co. Inc., pointed out earlier this month, productivity improvements generally run in long waves. Productivity improved at a 1.5% annual rate between 1889 and 1917 and then surged to a 3.8% annual rate between 1917 and 1927.

After slumping to a 1.8% rate between 1927 and 1948, it grew again at a 2.8% rate between 1948 and 1973. Productivity again slumped to a 1.4% rate between 1973 and 1995 before picking up to a 2.8% rate between 1995 and 2000, according to Mr. Steinberg.

Judging by that historical pattern, we have a few more years of high productivity growth ahead of us. That’s good for stocks and bad for inflation. And both of those are good for investors.

Mike Clowes is the editorial director of InvestmentNews.

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