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

Here is a question we have seen a few times in our mailbag this year: Shouldn’t you adjust stock market returns for inflation—i.e., discuss “real” returns? The sentiment is understandable, given the backdrop in 2022. And, lately, this has given rise to another question: Shouldn’t 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 paycheck, that is what shows up on statements and in brokerage accounts, making them the most meaningful. Furthermore, corporate earnings and fundamentals are also nominal, so adjusting stock returns would compare apples and squirrels, since a stock is a share in a company’s future earnings.

But that is just the tip of the iceberg. When statisticians adjust economic data for inflation, the goal is to remove skew caused by rising prices. Consider UK retail sales: For much of this year, growth in sales values was quite strong. But was that because prices rose, or because Brits bought more stuff? Enter the inflation-adjusted measure, sales volumes. It fell in seven of the nine months for which we have data so far. Similarly, nominal US GDP grew 6.6% annualized in Q1, 8.5% in Q2 and 6.7% in Q3.^[i] Without the inflation-adjusted dataset, we would never know whether this stemmed from rising prices or an actual increase in economic activity. Deflating the figures lets everyone zero in on what actually happened.

With earnings, however, adjusting for inflation would add skew rather than remove it. Earnings derive from two items: costs and revenues. Inflation impacts both. Companies face higher costs and raise prices of the goods and services they sell. Thus, 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 margins absorb the blow? If you were to deflate costs and revenues, you would lose that signal.

You would also end up with a number far removed from reality. After all, what would you use to deflate earnings? It isn’t as simple as applying the GDP deflator (or whatever) to the headline results. If you were playing by the book, you would use the producer price index (PPI) to deflate costs and either the consumer price index (CPI) or personal consumption expenditures (PCE) price index 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 or PCE to revenues keeps like with like. But, paradoxically, this would probably make earnings bigger. PPI has risen much faster than CPI—and faster still than PCE—throughout this inflationary spell. (Which is rather typical given the volatility of raw materials prices.) So the inflation adjustment would reduce costs more than revenues, skewing earnings upward—potentially far upward if you used PCE instead of CPI.

This same conundrum would apply to stock returns. What inflation adjustment would you use? We are hard pressed to think of one that makes logical sense, considering neither CPI nor PCE is a cost-of-living index. Plus, inflation isn’t the only thing that erodes stock returns. 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 S&P 500 would be down about -34% year to date at its latest low, were it not for the CPI inflation rate bumping it up to -25%. But if you think inflation—or at least the sentiment reaction to it—was a big contributing factor to this year’s bear market, why would you make that argument? A fast inflation rate cannot simultaneously be a negative and a positive for stocks. By a similar token, what about the bear markets that featured deep recessions with deflation? Should those nominal returns be adjusted higher to account for falling consumer prices? We are sure all 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. 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 will 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, medical costs, etc.), and then figure out the nominal long-term return you need to offset this and fund your lifestyle throughout your entire time horizon. Your returns may or may not keep pace with inflation every year, depending on market volatility, but it will be a much better roadmap than trying to apply an arbitrary statistical adjustment to returns in the here and now.