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Portfolio Asset Allocation Implications

stock prices declined. The common stock prices of oil companies, however, rose because their expected earnings were rising more rapidly than the rapidly rising rates. Oil companies’ expected earnings in the numerator of the Equation (3) valuation framework were rising at a faster rate than interest rates in the denominator.

The conception of common stocks as inflation hedges had to be tempered. Common stocks are only inflation hedges when the rate of increase in expected earnings induced by inflation exceeds the rate of increase in interest rates also induced by inflation.

Hyperinflation has led to extraordinarily high interest rates and total collapses of corporate profits, currencies and entire economies since the days of the Roman Empire. In terms of the Equation (3) valuation framework, expected earnings cannot achieve a sustainable, fast-enough rate of increase to exceed the rate of increase in interest rates. Common stock prices fall. Economies afflicted by hyperinflation usually regress to barter, political unrest and collapse, and sometimes, armed conflict. Investors flee. Corporations and common stock prices crumble in that environment. Common stocks are not a hyperinflation hedge.

Bond and Stock Price Linkage

Bond and stock prices are sometimes linked. Rising bond prices (declining interest rates) and rising common stock prices are seen as partners in bull markets. Declining stock prices and bond prices (rising interest rates) are partners in bear markets. This occurred in many years of the 1980s and 1990s when a relatively unique confluence of low and declining inflation and interest rates during economic expansion accompanied a rise in corporate efficiency and earnings. This is not the typical combination. Interest rates usually rise during economic expansion.

The link between bond and stock prices is expected only in Stage III and possibly in early Stage I. Bond and common stock prices should be unlinked in the other periods of the economic/stock price cycle (Exhibit 4.1).

The link between higher bond prices (lower interest rates) and higher common stock prices may occur relatively fleetingly in the beginning of Stage I, around the low in common stock prices, and in Stage III. In the beginning of Stage I, expected earnings are declining very slowly or rebounding while the economy remains in a recession



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	stock prices declined. The common stock prices of oil companies, however, rose because their expected earnings were rising more rapidly than the rapidly rising rates. Oil companies’ expected earnings in the numerator of the Equation (3) valuation framework were rising at a faster rate than interest rates in the denominator. The conception of common stocks as inflation hedges had to be tempered. Common stocks are only inflation hedges when the rate of increase in expected earnings induced by inflation exceeds the rate of increase in interest rates also induced by inflation. Hyperinflation has led to extraordinarily high interest rates and total collapses of corporate profits, currencies and entire economies since the days of the Roman Empire. In terms of the Equation (3) valuation framework, expected earnings cannot achieve a sustainable, fast-enough rate of increase to exceed the rate of increase in interest rates. Common stock prices fall. Economies afflicted by hyperinflation usually regress to barter, political unrest and collapse, and sometimes, armed conflict. Investors flee. Corporations and common stock prices crumble in that environment. Common stocks are not a hyperinflation hedge.

	Bond and Stock Price Linkage Bond and stock prices are sometimes linked. Rising bond prices (declining interest rates) and rising common stock prices are seen as partners in bull markets. Declining stock prices and bond prices (rising interest rates) are partners in bear markets. This occurred in many years of the 1980s and 1990s when a relatively unique confluence of low and declining inflation and interest rates during economic expansion accompanied a rise in corporate efficiency and earnings. This is not the typical combination. Interest rates usually rise during economic expansion. The link between bond and stock prices is expected only in Stage III and possibly in early Stage I. Bond and common stock prices should be unlinked in the other periods of the economic/stock price cycle (Exhibit 4.1). The link between higher bond prices (lower interest rates) and higher common stock prices may occur relatively fleetingly in the beginning of Stage I, around the low in common stock prices, and in Stage III. In the beginning of Stage I, expected earnings are declining very slowly or rebounding while the economy remains in a recession