Why Does Inflation Cause Stock Prices to Decrease?

The Small Investor

With inflation, the prices of things generally increase.  You would therefore expect the prices of stocks to rise as well.  This is true during the latter stages of inflation, but initially equity prices may actually fall.  Here’s why:

The price of a stock includes a “discount” to its fair value due to the perceived risk involved.  For example, say that a stock normally trades for about ten times its earnings (its price-earnings ratio, PE, is 10).  This is the price that the market has set for the company, and like other things, the price may fluctuate a bit but over long periods of time the price will remain about the same.  If earnings were expected to rise by ten percent in the next year, you might expect the stock to increase ten percent as well in expectation of the earnings increase so that the PE ratio would remain around 10.  If…

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