For long-term investors, stocks remain the inflation hedge we were always taught they would be. By Jeremy J. Siegel, Contributing Columnist July 31, 2006 A lousy inflation number comes out of Uncle Sam's data mills and stocks tank. Yet investors are taught -- rightly, I might add -- that stocks are good hedges against inflation because they are claims on real assets, such as plants, land and intellectual property. The value of these assets generally rises with prices. Bonds, which are promises to repay debts in dollars, should suffer when inflation worsens. But why should stocks?Long-term edge Over long periods, stocks do in fact rise along with prices. Inflation since World War II has greatly exceeded pre-war inflation, yet the real, after-inflation return on stocks has been unaffected, averaging 6.5% to 7% per year. This has been confirmed over other long periods as well. But over shorter periods, it is a different story. From 1966 through 1981, when inflation averaged more than 7% per year, real stock returns were actually slightly negative (long-term bonds did even worse). This was one of the few long periods when gold and other tangible assets outpaced stocks. Stocks performed poorly for several reasons. First, inflation was spurred by rising oil prices. Since we import large quantities of petroleum, oil-price increases inflate most production costs, reducing consumer income without an offsetting rise in income for domestic oil producers. But there are other reasons that stocks may fare poorly in inflationary periods. Our tax system -- which is based on accounting values that are not adjusted for changes in price levels -- penalizes corporations and stockholders during periods of rising prices. That is because the tax code does not allow companies to index the cost of their assets to inflation. So companies are unable to adequately depreciate the increasing cost of capital spending. Advertisement As for shareholders, they are taxed on nominal capital gains -- that is, with no adjustment for inflation. If an investor buys a stock at $20 and ten years later sells it for $30, he or she hasn't really made anything if overall prices have risen by 50%. Nevertheless, the government taxes investors on the $10 inflationary gain. There is another, perhaps even more important reason stock prices fall when inflation threatens. The Federal Reserve has resolved to fight inflation by raising interest rates. To fight inflation effectively, the Fed must raise rates by more than the expected rise in prices -- in other words, raise the real rate of interest. The Fed learned this lesson when it failed to hold down rising prices in the 1970s and was then forced to raise interest rates to extraordinary levels in the early 1980s to squelch inflation. Rising real rates hurt the prices of all assets -- stocks, bonds and even commodities. That is because as cash becomes more attractive to hold, the appeal of long-term, riskier assets diminishes. Finance theory teaches that the real interest rate is the proper rate at which investors should discount future corporate profits -- even the profits of those companies that can raise prices in line with inflation. So when real rates rise, the price of real assets, such as stocks, should fall, even if companies can raise prices enough to keep up with inflation. Advertisement Fed worries Behind the stock market's recent travails were suggestions by the Fed that higher real rates might be needed to tame inflation. Without knowing how high the Fed would raise rates, stocks stumbled badly. Once the current tightening cycle is over and the Fed stops raising rates, stocks will rebound and more than make up for inflation. The bottom line is that although inflation is bad for stocks in the short run, in the long run stocks will rise along with the general increase in the prices of goods and services. For long-term investors, stocks remain the inflation hedge we were always taught they would be. Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.