I give the same answer to both questions: inflation has no discernible effect on the value premium, and that does not matter because most investors will outpace inflation if they remain invested.
The idea of shifting into asset classes as they outperform and dumping them before they underperform is appealing in theory. But countless studies illustrate how hard this is for any individual investor, professional or amateur to do in practice.
This is because security prices quickly incorporate new information and reflect the aggregate expectations of market participants. That includes new information and expectations related to economic factors, like inflation, as well as their potential impact on the future cash flows and discount rates of companies.
Any individual investor is competing against that powerful collective force.
If, as some people suggest, higher inflation signals a positive value premium, we would see a regular pattern in the relation between inflation and the premium.
The chart below shows that relation between the value premium and inflation in the US from 1927 to 2022. If a positive relation existed we would see a linear pattern running from bottom left to top right. All I see is randomly placed dots congregating around a positive average premium.
The way to handle this realisation is to remain consistent with your strategy. Value investors are better off holding their diversified value portfolios through thick and thin. The past couple of years are a good illustration of why.
In the three years to June 2020, US value and growth stocks returned -3.1 per cent and 17.6 per cent respectively, with inflation at around 2 per cent.
In the two-plus years since (July 2020 to December 2022), value has returned 28.7 per cent to growth’s 6.6 per cent, with inflation at an average of around 6 per cent to 7 per cent. Some might look at that coincidence of higher inflation and a strong value premium and search for causation in the correlation.
But this period gives us nothing more than a few dots in a chart with no discernible relation. No one knew when exactly the value premium would turn positive, just as no one knows exactly when it will turn negative. The best approach is to expect it to be positive on any given day and to be well positioned when it is.