The storm flags are now flying, warning of inflation that is likely to be the natural outcome of the Obama administration’s “spending is stimulus” programs.

Fed Chairman Bernanke, so far, has not presented a convincing plan on how the country will be able to pay for the multi-trillion dollar spending orgy that President Obama has ordered.

Now the question is how can investors protect financial assets from inflation? Gold? Real estate? Equities? Commodities?

For young people, with twenty or thirty years before they retire, there is time to recover from a bad decision. However for those entering into retirement, or already there, there is little or no room for error.

In this article I examine the inflation-resistant features of equities, specifically index funds. I’ve chosen index funds because this vehicle is now very popular with those seeking to reduce risk by diversification and low management fees.

Stock index funds also can represent equities as a generic investment, rather than results from a particularly good or bad individual stock selection.

Stocks in an inflationary environment: Brazil 1968-2004

The following graph shows the evolution of Brazilian stock prices over a 36 year period that takes in the “Brazilian Miracle”, the election of leftist governments in the early 1980s, the hyper-inflation of the late 1980s and early 1990s, and the return of centrist governments and economic recovery in the late 1990s and early 21st century.

The red and gray lines represent the stock price indices on the São Paulo (red) and Rio de Janeiro (gray) stock exchanges, deflated by the local cost of living index.

The green line represents the São Paulo stock index converted into US dollars.

Throughout this period, there were many well-established and highly successful companies traded on the Brazilian markets, representing a widely diversified selection of industries with worldwide clients, such as the Gerdau steel group and Vale do Rio Doce.

Throughout most of this period, inflation ran about 20-25% a year, except in the early 1990s, when there was hyperinflation of over 1000% a year.

The period encompassed governments on the right, center, and left, varying from good to terrible.

John Pierpont Morgan was right

Over 100 years ago, when J.P. Morgan was asked what stocks would do tomorrow, he replied, “They will fluctuate”. And this was at a time when the US dollar was convertible into gold.

The graph of Brazilian stocks against inflation illustrates the truth of Morgan’s statement in an extreme inflationary environment.

Inflation confounds estimates of intrinsic value of securities because of increased uncertainty about future interest rates and because accounting standards are not designed to adjust financial statements for the effects of inflation.

Therefore, in an inflationary environment, market volatility increases.

On the Brazilian stock index graph, we see that in this 36 year period, stock prices rose ten-fold and dropped 90%, twice — extreme volatility to match extreme inflation.

Furthermore, the graph shows that in US dollar terms, Brazilian stocks offered no protection at all against inflation.

This, in part, reflects government distortion of the consumer price index (all governments, including the US government, do this, especially in an inflationary environment).

In part, the weakness against the dollar reflects capital flight away from a weak currency to a stronger currency.

There is no “good government” with inflation

The Brazilian stock index graph shows two and one-half major cycles.

The first cycle, from 1968 to 1980 was during the period of the Brazilian Economic Miracle, with fast growth of GNP, rapid industrialization, and relatively high employment and good times.

However, at the beginning of the period, the government had a policy of encouraging public investment in shares, which was not calibrated with the supply of shares, resulting in the Boom of 1971, vastly over-priced equities, followed by a collapse in values over nine years.

The second cycle, from 1981 to 1990, was characterized by the end of the Brazilian Miracle and the advent of leftist governments, wild spending, and lack of fiscal discipline, typified by Guanabara Governor Leonel Brizola — similar in fiscal policies to the current Obama administration.

At first, because stock prices rose sharply, in part because prices had fallen to low levels from the peak in 1971 and partly because of the stimulus effect of undisciplined spending that generated optimism.

However, over-spending (even in an environment of endemic inflation), finally led to hyper-inflation of over 1000% by the end of the decade.

This led to a change in government and move back from the left to the center, with recovery in stock prices by the new century.

Lessons from history

The behavior of the Brazilian stock market in an inflationary environment from 1968 to 2004 suggests the following:

• Inflation increases stock price volatility.
• An equity market with an inflationary currency will under-perform a market with a less inflationary currency.
• A stock index fund does not insulate investors from the effects of inflation.

This suggests that American retirees who are relying upon the Common Stock Legend and index funds to survive the inflation which seems to be coming, will not be protected.

If you must invest in a stock index fund, it would seem prudent to at least chose a fund relative to a stock market in a country that has less chance of inflation than the United States.