May 23, 2013

Investors celebrated this spring as major U.S. stock market indexes hit record highs, finally surpassing the prior peak reached in October 2007 before the onslaught of the financial crisis the following year.

When adjusted for inflation, however, the stock market is a long way from setting new records. At the end of the first quarter, the S&P 500 Index stood 30% below the inflation-adjusted peak reached in 1999 (not including dividends).

Figure 1: S&P 500 Index

Despite that reality, investors looking to preserve purchasing power over the long term should recognize that equities have historically provided one of the best defenses against inflation over time.

Although inflation has been relatively tame in recent years, it is a key concern for investors over the long term since rising prices erode purchasing power and cut into investment returns. An average annual inflation rate of 3% would cut the value of a dollar in half over 23 years. Inflation averaged just 1.8% over the past five years but about 2.9% over the prior 30 years.

The table below shows the percentage of rolling investment periods in which various assets beat inflation from 1950 through 2012. Over shorter investment horizons of one, five, or even 10 years, stocks failed to outpace inflation in more than 20% of the periods, but bonds and cash also had spotty records.

Over 20- or 30-year periods, however, stocks beat inflation in every one, while bonds had positive real (inflation-adjusted) returns 92% of the time. This means that bond returns lagged inflation in 32 of the 397 rolling 30-year periods (calculated monthly), most of these occurring in the 30-year periods ending in the mid-1960s through the early to mid-1980s.

Also, the magnitude of the outperformance for stocks was significant. Over the entire 63-year period, large-cap stocks had an average annual real rate of return of 7.0% compared with about 2.6% for bonds and 0.8% for cash (30-day Treasury bills). Stocks also outperformed bonds on a real return basis in virtually all of the 20- and 30-year periods, usually by a wide margin. Of course, stocks are generally more risky than bonds, but the volatility of stocks is significantly reduced over longer-term periods.

Performance of Financial Assets Relative to Inflation for Various Holding Periods

Percentage of rolling periods in which stocks, bonds, cash and selected portfolio strategies
Outpace Inflation: December 31, 1949-December 31, 2012

Performance of Financial Assets Relative to Inflation for Various Holding Periods

While stocks outpaced inflation and other assets over most short-term periods in this study, Rich Whitney, the firm's director of Asset Allocation, says equities have a good track record relative to inflation because "equities are valued based on earnings, and over the long term, earnings have outpaced the real growth in the economy. As long as earnings are not declining on an inflation-adjusted basis, equities should be a reasonable way to insulate yourself against the ravages of inflation."

Whitney adds, however, that in the short run, the positive relationship between stocks and inflation has been less reliable because "many other factors come into play, such as M&A [merger and acquisition] activity, valuations, levels of interest rates, investors' risk appetite, or extreme inflation, such as we experienced in the 1970s."

Indeed, stocks lagged inflation over almost all of the rolling 10-year periods ended May 1974 through March 1983 and more recently in the periods ended February 2008 through December 2011. Inflation proved a tough bogey as it began rising in the latter 1960s and skyrocketed in the 1970s, actually reaching double digits. Neither stocks nor bonds provided a positive real rate of return in the 1970s.

While inflation was below average over the past decade, two historic bear equity markets (in 2000-2002 and 2008-2009) savaged stock prices. Equities had negative real returns for most of these more recent 10-year periods, but bonds provided positive real returns as interest rates have declined in recent years to record-low levels, pushing bond prices up.

This is another reason it makes sense for investors to remain diversified, taking advantage of the inflation-beating potential of stocks over the long run and the reduced volatility of bonds in the shorter term. A portfolio of 80% stocks and 20% bonds would have outpaced inflation in all of the rolling 30-year periods in this study and would have provided a real annualized return of 6.3% since 1950, and 7.0% over the past 30 years. Of course, past performance cannot guarantee future results. Diversification cannot assure a profit or protect against loss in a declining market.

Since the stock market bottomed in March 2009, the S&P 500 Index has more than doubled. Notwithstanding that remarkable comeback, T. Rowe Price managers caution investors to lower their expectations for nominal equity returns in the coming years, but real returns could remain attractive.

"If we thought of 8% to 10% as a normalized expectation range for equity returns a decade ago, I think an average return of 6% to 8% would be a reasonable expectation over the next five to 10 years," says John Linehan, the firm's director of U.S. Equity. "But compounding 6% to 8% is a very effective return, especially in an environment with low yields and low inflation."

This material is provided for informational and educational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This article provides opinions and commentary that do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only. The views contained herein are as of March 31, 2013, and may have changed since that time.