the other hand, have not matched the returns on stocks over any holding
period.
This was the principal conclusion of Edgar L. Smith’s 1924 book
Common Stocks as Long Term Investments. He showed that stocks outper-
form bonds in times of falling as well as rising prices, taking the period
after the Civil War up to just before the turn of the century as his test
case. Smith’s results are robust and have held up to more than 80 years
of subsequent data.WHY STOCKS FAIL AS A SHORT-TERM INFLATION HEDGEHigher Interest Rates
If stocks represent real assets, why do they fail as a short-term inflation
hedge? A popular explanation is that inflation increases interest rates on
bonds, and higher interest rates on bonds depress stock prices. In other
words, inflation must send stock prices down sufficiently to increase their
dividends or earnings yields to match the higher rates available on bonds.
Indeed, this is the rationale of the “Fed model” described in Chapter 7.
However, this explanation is incorrect. Certainly, expectations of
rising prices do increase interest rates. Irving Fisher, the famous early-
twentieth-century American economist, noted that lenders seek to pro-
tect themselves against inflation by adding the expected inflation to the
real interest rate that they demand from borrowers. This proposition has
been called the Fisher equation, after its discoverer.^10
But higher expected inflation also raises the expected future cash
flows available to stockholders. Stocks are claims on the earnings of real
assets, whether these assets are the products of machines, labor, land, or
ideas. Inflation raises the costs of inputs and consequently the prices of
outputs (and those prices are in fact the measure of inflation). Therefore,
future cash flows will also rise with the rise in price levels.
It can be shown that when inflation impacts input and output
prices equally, the present value of the future cash flows from stocks is
not adversely affected by inflation even though interest rates rise.
Higher future cash flows will offset higher interest rates so that, over
time, the price of stocks—as well as earnings and dividends—will rise atCHAPTER 11 Gold, Monetary Policy, and Inflation 201
(^10) See Irving Fisher, The Rate of Interest, New York: Macmillan, 1907. The exact Fisher equation for the
nominal rate of interest is the sum of the real rate plus the expected rate of inflation plus the cross
product of the real rate and the expected rate of inflation. If inflation is not too high, this last term
can often be ignored.