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The Impact Of Inflation On Stocks


Inflation (in moderation) is actually a good thing for the economy.


With commodity prices going through the roof, there is understandably increased concern about inflation sapping the economy and pushing interest rates higher. It was only a few years ago that the main concern was about deflation. In fact, the current Fed Chairman Bernanke came to notoriety by writing and speaking about the perils of deflation.

Inflation (in moderation) is actually a good thing for the economy. The reason for this is our economy's reliance on debt. Debt can more easily be serviced by debtors (the government is a huge debtor) by returning borrowed money with "less expensive" dollars – less expensive because of inflation. The economy would grind to a halt if deflation caused debt to be serviced with "more expensive" dollars.

So, let's see if the charts confirm that inflation is good for the stock market:

The above chart shows the CPI (which includes food and energy prices) along with the Core Inflation (excluding food and energy prices.) The above chart shows that the CPI is more volatile and leads the Core Inflation measure. So, food and energy prices are "high beta" when it comes to the direction of inflation. How does this relate to equity prices?

The above chart shows the net difference between the CPI and the Core inflation rate, along with the S&P 100 index. Since 1990 all periods during which this measure rose from low levels (green arrows) either spurred the market higher or led a market upside reversal (2003.) Those moments when this measure fell from high levels are even more interesting. Prior to 2000, these moments seemed to slow the market's progress. After 2000, a turndown in this measure was right in line with the market's collapse. Perhaps this measure of the "CPI minus the Core inflation rate" is a marker for secular bull and bear markets - how the market responds to the "CPI minus the Core inflation rate" cyclical shifts tells us the secular nature of the market. We have maintained that the current market is in a bear secular trend and is likely to remain so this decade. How the market reacts to the next downturn in the "CPI minus the Core inflation rate" will be a clue to its secular nature. Stay tuned for that!

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No positions in stocks mentioned.

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