From the Mailbag: Some Considerations About Those ‘Real’ Returns

Here is a question we have seen a few times in our proverbial mailbag this year: Shouldn’t you adjust stock market returns for inflation (broadly rising prices across the economy)—i.e., “real” returns? We understand the sentiment, given the backdrop in 2022. And, in our experience, this has given recent rise to another question: Shouldn’t corporate earnings be adjusted for inflation? But in our view, there are some pretty big drawbacks we think anyone considering these practices ought to weigh.

To start with, investors earn nominal (meaning, unadjusted) returns. Like a worker’s paycheque, that is what shows up on statements and in brokerage accounts, making them the most meaningful, in our view. Furthermore, corporate earnings and fundamentals are also reported on a nominal basis, so adjusting stock returns would compare apples and squirrels, if you will pardon the metaphor, since a stock is a share in a company’s future earnings.

But that is just the beginning. In our experience, statisticians typically adjust economic data for inflation to remove skew caused by rising prices. Consider UK retail sales: For much of this year, growth in sales values was quite strong.^[i] But was that because prices rose, or because people actually purchased more goods? Enter the inflation-adjusted measure, sales volumes. It fell in seven of the nine months for which we have data so far this year.^[ii] Similarly, nominal US GDP (gross domestic product, a government-produced measure of economic output) grew 6.6% annualised in Q1, 8.5% in Q2 and 6.7% in Q3.^[iii] Without the inflation-adjusted dataset, it is likely we would never know whether this stemmed from rising prices or an actual increase in economic activity. Deflating the figures gives investors an idea of what actually happened—slight Q1 and Q2 contractions, followed by growth in Q3.^[iv]

With earnings, however, we think adjusting for inflation would add skew rather than remove it. Earnings derive from two items: costs and revenues. Our research suggests inflation would normally impact both concurrently. Companies face higher costs and raise prices of the goods and services they sell. Thus, in our view, unadjusted earnings are a crucial way to see whether companies were able to make money despite rising costs. Were they able to raise prices to compensate? Make cutbacks elsewhere as raw materials got more expensive? Or did they take the hit and let their profit margins absorb the blow? If you were to deflate costs and revenues, we think you would lose that signal.

You might also end up with a number far removed from reality. After all, what would you use to deflate earnings? We don’t think it is as simple as applying the GDP deflator (which is the rate used to adjust GDP for inflation in a given quarter) or another similarly broad measure to the headline results. If you were playing by the book, we think you would use the producer price inflation (PPI) rate to deflate costs and the consumer price inflation (CPI) rate to deflate revenues. Companies pay producer prices for raw materials, energy and other inputs, and they receive consumer prices in the marketplace, so applying PPI to costs and CPI to revenues keeps like with like. But, paradoxically, this would probably make earnings bigger. PPI has risen faster than CPI throughout this inflationary spell.^[v] (Which our research finds is rather typical given the volatility of raw materials prices.) Therefore, the inflation adjustment would reduce costs more than revenues, skewing earnings upward.

This same conundrum would apply to stock returns. What inflation adjustment would you use? We struggle to think of one that makes logical sense, considering CPI isn’t a cost-of-living index. Plus, inflation isn’t the only thing that erodes stock returns, in our view. Should we also adjust them for capital gains taxes? Income taxes?

Lastly, we see a basic logical issue here. Essentially, someone arguing that returns should be inflation-adjusted is arguing that the US-orientated S&P 500 would be down about -34% year to date at its latest low, were it not for the US CPI inflation rate bumping it up to -25% in dollars.^[vi] But if you think inflation—or at least the sentiment reaction to it—was a big contributing factor to this year’s downturn, why would you make that argument? We think common sense suggests a fast inflation rate cannot simultaneously be a negative and a positive for stocks. By a similar token, what about past bear markets (prolonged, fundamentally driven broad equity market declines of -20% or worse) that featured deep recessions with deflation—the opposite of inflation? Should those nominal returns be adjusted higher to account for falling consumer prices? We doubt those who lost great fortunes in the early 1930s would be very comforted to know that, adjusted for deflation, their returns don’t look as bad.

With all that said, we understand the impetus for wanting to adjust returns for inflation. In our experience, many long-term investors are seeking to fund their retirement, which means covering living expenses now and in the future. That makes inflation a very real variable affecting whether they reach their long-term goals. But rather than try to adjust for inflation, we think it makes more sense to assess your personal living costs. Estimate how much they are likely to rise over your investment time horizon (you can use the historical average inflation rates for the relevant CPI subcategories, e.g., food, shelter, etc.), and then figure out the nominal long-term return you need to offset this and fund your lifestyle throughout your entire time horizon.^[vii] Your returns may or may not keep pace with inflation every year, depending on market volatility, but we think it will be a much better roadmap than trying to apply an arbitrary statistical adjustment to returns in the here and now.