Stocks as a Hedge against Inflation: Does Corporate Profitability Keep Up with Inflation?

Fundamentally, stocks are a good hedge against inflation if corporate profitability keeps up with inflation. Using monthly stock-market data covering over 151 years, from 1871 to 2022, this article analyzes the relationship between inflation and corporate profitability, measured by dividend-equivalent earnings discounted at the risk-free rate. The relation between corporate profitability and inflation varies across sample periods, time horizons, and ranges of inflation. Corporate profitability tends to be positively related with demand-pull inflation, and negatively related with cost-push inflation. More interestingly, corporate profitability is the highest when inflation is modest (0%–4%), and it is very low when inflation is very low (deflation) or very high (over 10%). Based on this finding, what really matters for corporate profitability seems to be long-term economic stability, as opposed to a temporary setback. High inflation, itself, may not lower corporate profitability, although it can signal lower corporate profitability. Negative stock market reactions to high inflation itself may create buying opportunities.