Inflation and Stocks
đ° Monday, December 29, 2025
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Why âshouldâ stocks grow exponentially over long periods of time
The underlying premise of the FVE algorithm is that the stocks of companies grow exponentially over time. One of the primary reasons for this phenomenon is that underlying inflation grows exponentially over time, as tracked by the consumer price index (CPI), for example. The "exponential" part comes from the fact that inflation (and business growth) is multiplicative, not additive. If inflation is 2% every year, prices increase 2% from the previous year's price, not the starting price.
Letâs consider this simple example:
Suppose the fictional Orchard Incorporation sells $100,000 of apples in year 1 of their company. In year 2 of their company, labor and fertilizer go up by 2%, and thus they raise their prices by 2%. Orchard Incorporation has prudent management and strives to keep their profit margin constant at 20%. Their absolute profit increases by 2% even if they don't sell a single extra apple. Indeed, in year 2 they sell the same amount of apples for $102,000.
In year 1 they earn $20,000 at a 20% margin
In year 2, they earn $20,400 at a 20% margin
This is called nominal earnings growth, and that extra $400 is "new" money that increases the company's valuation in nominal terms. Nothing changed except inflation.
Assuming this company continues to maintain a constant margin over time, and inflation is 2% a year, their nominal earnings growth will be 2% a year. The valuation of a company is based on the earnings it produces, or its future earnings potential, and hence the price of Orchard Incorporation should (over the long term) increase at least 2% a year from nominal earnings growth, which is the inflation rate. When you hear that stocks are a good âhedgeâ against inflation, this example demonstrates that concept â itâs better to be a shareholder in fictional Orchard Incorporation than hold cash, which will lose value due to inflation. However, this framework does not work out if Orchard Incorporation has poor management, and canât maintain these business performance parameters, which is why investing in companies involves risk. One way to mitigate this risk is through diversifying your investment portfolio into a basket of stocks, or alternatively, an index fund.
But there is more to the story. Orchard Incorporation has a decision to make. Do they want to return the profits of the company back to the owners of the company, or do they want to âplowâ (no pun intended) the profits back into the business to buy more land, plant more apples trees, and increase the number of apples they are selling?
It depends on what the shareholders want, of course.
If Orchard Incorporation has shareholders near retirement age that are risk averse, and are looking for income from their shares in the company, the management of the company will keep the farm the same size, return most of the profits to the shareholders (otherwise known as a dividend), and the growth rate of the company will be closer to the nominal rate of inflation.
On the other hand, if Orchard Incorporation has shareholders who are young whipper snappers with long lives ahead of them, and donât depend on the income from their Orchard shares, the management will take those profits to buy new land, plant more apples, and expand the business. This is called reinvestment growth, and may allow the revenue of the company to increase, and the earnings to grow much faster than nominal growth. This approach can be higher risk, if the reinvestment doesnât translate to higher revenue.
There are other factors that might influence which approach a company may take such as competition from another apple orchard, and the specter of losing business unless they keep growing revenue.
We return to how this relates to the FVE algorithm. As we stated in Blog 2 back on June 23, 2025, to embrace our methodology, users must agree with a relatively simple underlying axiom: over long time intervals, a US based broad market or sector ETF has an innate and relatively consistent exponential growth rate. This rate is impacted by various factors, including the existence of stable and persistent inflation, the market capitalization size of its constituents, or the particular business attributes of its members.
The QQQ ETF, which tracks the Nasdaq 100, is an example of a fund having many Case 2 companies above. Companies in the QQQ are generally oriented towards technology and innovation, and many of them aggressively reinvest earnings to capture more market share, hoping to generate higher revenue growth, and stock price appreciation. This has been even more pronounced in recent years due to the AI buildout.
While an individual growth stock can be volatile or even fail, an index like the Nasdaq 100 uses diversification to mitigate idiosyncratic risk. By investing in a basket of 100 leaders, the "noise" of one company's struggle is offset by anotherâs success. This collective action mollifies volatility, smoothing out the cumulative earnings growth of the fund, resulting in predictable exponential price appreciation over long periods of time, which the FVE exploits.
Moreover, the QQQ, like most ETFs we track, is a 'self-healing' organism; when a companyâs exponential growth fails, it is removed from the index and replaced by a rising star. This systematic pruning ensures the ETFâs cumulative growth curve remains intact even as individual companies come and go.
In our view, stable inflation growth is the primary foundational factor which leads to reliable stock price appreciation over a many decades long time frame. This underscores the importance of an independent Federal Reserve striving to keep the inflation rate near a constant low rate, regardless of the political whims and whinings of the moment. Not surprisingly, countries and regions of the world that have inconsistent inflation trajectories have volatile and unpredictable stock markets, making it hard to model with our FVE valuation framework.
In January, you can expect two blogs. Our first note will be a year end performance review of the trading strategies with our outlook for 2026. Our second note will continue our discussion on inflation and apply our FVE to the consumer price index, a primary measure of inflation, to see where inflation âshouldâ be based on the last 40 years of reports.
đ FVEr Weekly Market Update: December 29, 2025
Since our last blog on November 24, 2025, US markets have been relatively subdued and mostly regained their mid-November highs with a modest rally. Out of 25 broad market ETFs that we cover, 23 are over-valued relative to the FVE, indicating a continued expensive global stock market. However, the relative valuations across the investing universe we cover has shrunk. Underperforming areas like small and mid caps, as well as value ETFs, have had decent last quarters, while the AI trade has been sideways, leading to a more balanced market moving into 2026.
In the last blog we also highlighted XLB (SPDR S&P 500 Materials) as one of the best opportunities in the US market. Since then the sector has rallied 5.5% and is moving out of leverage this week for the first time in 13 weeks.
See you next time. In the meantime, please don't hesitate to reach out if you have any questions.
The FVEr Team
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