COMMON STOCK AS A HEDGE AGAINST INFLATION

Inflation has a profound impact on the real value of shares in the stock market. Rational investors respond to inflation by revising their expectations and adjusting their requied rate of return on one for one basis to maintain the real value of their assets. They also select a class of equities that are highly responsive to rise in the general level of prices. The risk of inflation or purchasing powe risk arises from error in investors’ prediction and when actual inflation deviates from expected inflation. A higher than expected inflation reduces share prices because of immediate jump in investors’ required rate of returns which, in turn has a negative impact on the present value of cash flow of the firms. Conversely a lower than expected inflation rate reduces investors required rate of return and will cause share prices to increase. Most financial analysts believe that tangible assets, such as real estate, gold and commodities are good hedge against inflation. Common stock wer also traditionally believed to be a good hedge against inflation because of the fact that their value represent a fractional ownership in the real assets of the companies. The theoretical base for this argument is an extended version of Fisherian Hypothesis FH which suggests that real return on stocks is determined by real variables andis independent of inflationary expectation. To date, however most previous studies have rejected this hypothesis and have documented that all measures of inflation are negatively correlated with share prices. This include the result of papers by Pearce et al (1988) and an article by Ely and Robinson (1989) that have tried to solve this puzzle and provide some theoretical explanations for this market anomaly. They include risk premium hypothesis, tax effect hypothesis, money illusion hypothesis and proxy hypothesis. No consensus of opinion has emerged so far to overwhelmingly support one hypothesis or another.

One study examines the impact of both expected and unexpected inflation on Iranian shares over the period 1991- 1995. the general price level in Iran has followed a steep upward trend in recent years as a result of rapid growth in liquidity, pressure from huge investments, especially in infrastructure, and adjustments in the exchange rates. This among other things has led the private investors towards rent seeking rather than genuine economic activities. It has become government priority to redirect investable funds to manufacturing through different procedures, including privatization of public companies and offering of their shares in the stock market. Obviously the success of this policy largely depends on whether return on shares is high enough to at least cover for inflation. Iranian shares are traded in Tehran Stock Exchange which was closed after the Revolution and reopened in oct 1989. Although, the en of war with Iraq in 1988 created substantial hope and positive sentiments in the market, the economic environment was still unstable and the future seemed uncertain to investors. Under such conditions, planning for large long term projects are sacrificed for smaller short term investments which can weaken investment growth. Iranian stock market was highly volatile from the beginning and investors were trading on the overwhelmingly short term positive technical dynamic which was fuelled by enormous liquidity. The excess demand for shares boosted the average share prices by nearly 500% during a period of more than two years (the Tehran Exchange Price Index TEPIX increased from 100 to 485 from March 1990 to May 1992. this boosted the average price earning ratio to such a level that did not seem to be sustainable in the long term. A market crisis which was expected for some time unraveled in late June 1992 and share prices dropped by 19.5% during aperiod of more than one year (TEPIX dropped from 485 to 391 between July 1992 and August 1993). From September 1993 TEPIX has followed an upward trend, again and reached to the record level of 1150 in December 1995.

Markets in developed economies usually follow the high growth rate, high inflation low growth rate, low inflation cycle. Empirical evidence from these markets indicate that stocks’ poor performance during inflationary periods is more than compensated by high real returns in periods of price stability. As a result, investors’ real return is positive in the long run. Iranian stock market has not experienced a period of price stability since it was reopened in 1989. Here, the important question is whether real return on shares is still low or negative when inflation becomes a long term phenomenon. Answer to this question has important implication for the success of government’s privatization policies and growth in private investments. Efficient Market Hypothesis EMH suggests that expected inflation is already embodied in share prices and only unexpected component of this variable may have a surprise impact on equities. Rational Expectation Hypothesis (hereafter REH), also suggests that share prices embody all available information and only move in response to those currently incoming information which have not been expected by market. Financial markets in developing countries are more restricted and information is not readily available to the public. As a result they are less likely to be efficient. We use these theoretical framework to shed some light on the extent of efficiency and rationality of Iranian stock market. Investing in gold and foreign currencies in the black market are a substitute for genuine long term investments during political and economic crisis. Present study compares the rate of return on equities with returns from investing in gold and foreign currencies. A superior performance of stock market is an indication of investors’ confidence in future economic stability. The contribution of private investment in economic growth is not limited to domestic investors. A comparison of findings indicated that foreign investors’ real return is higher than domestic investors. This is due to the fact that the value of foreign currency in the black market did not increase as fast as domestic inflation. It is needless to say that the estimated returns in this section suffer from the same type of short comings that appears in the calculation of real returns for domestic investors.
COMMON STOCK AS A HEDGE AGAINST INFLATION: From the First financial Seminar in Iran, Shahid Beheshti Univ., 1996