There is no disputing the failure of equities to protect the investor against inflation in recent years: The value of corporate equity holdings of U.S. households dropped from 144 per cent of disposable income in 1968 to 59 per cent in 1976. But this experience lends no plausibility whatever to the argument that bonds are a better hedge against inflation merely because their current yield is twice that of stocks.
According to Irving Fisher, expectations of future price increases should generate a premium over and above the real interest rate equal to the expected inflation rate. Because the inflation premium is taxable, however, high nominal bond yields by no means solve the problem of conserving capital during inflation.
Nor is it correct, in an inflationary environment, to refer to bonds as “riskless.” Good bonds are riskless, or nearly so, only with respect to default risk. They are exposed to market risk from changes in interest rates and to purchasing power risk from changes in the inflation rate. If, on the other hand, inflation is brought under control, and interest rates fall, it will no longer be possible to reinvest coupon income at the rate of interest prevailing when the bonds were originally purchased. But the rise in bond prices will be limited by call features and sinking funds that reduce their effective maturity.
Adequate equity prices are an essential condition of continued growth in output and employment—our major economic objectives. In the euphoria that preceded the present gloom, some investors believed the stock market would outperform the economy forever. Today the opposite belief—that the market will always underperform the economy—seems to have taken hold. That belief has implications that go far beyond the question of investment performance.