Inflation

High inflation continues to dominate the headlines, but it is only one piece of the “weight of the evidence” that’s stacked against the stock market. Still, in ironic fashion, stock-market action itself suggests that inflation is set to peak.

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The market impact from money printing has been underwhelming when adjusted for the inflation it’s unleashed. Measured from the peaks associated with the first attempt at Quantitative Tightening, in inflation-adjusted terms, Small Caps, EAFE, and Emerging Markets all have losses.   

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Many economists recommend equity investors to instinctively and aggressively “buy” the inflation peak. History is on their side, though not as overwhelmingly as they might believe.

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Forget interest-rate hikes and quantitative tightening. There exists a very important weapon in the fight against inflation that the Fed did not have at its disposal in the 1970s: an overvalued stock market.

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An already-low unemployment rate has dropped another 0.3% YTD (to 3.6%) and stocks’ rebound in the second half of March took the S&P 500 to within 3.5% of its all-time high. Yet Consumer Sentiment has sunk to 59.7—a reading that’s 15 points below the average seen at the last six NBER business-cycle troughs. Why the long faces?

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They are simple measures, but our “NOPE” Indexes capture (as well as anything) the escalating inflation squeeze on businesses and consumers. To recap, the NOPE is the spread between the ISM New Orders Index and the Price Index, which can be calculated for both the Manufacturing and Services sectors.

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For months, we’ve argued there are two ways of thinking about the current economic cycle. Economist types are likely to side with their brethren at the NBER, who say the recovery has entered its 23rd month. But those observing the broad range of economic and financial gauges might view this cycle as a  single economic expansion dating back to mid-2009.

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PPI and CPI inflation reached levels that were “too hot to handle” last April and July, respectively, yet the blue chips kept going up through year-end. Large Cap investors who trimmed stocks in response to the violation of these long-time inflation speed limits, however, haven’t missed out on much, and Small Cap investors who did so are happy.

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Last year’s consensus view that inflation would prove “transitory” missed the mark. There’s no reason for shame; inflation forecasting hadn’t been a required investment skill for the previous 30 years.

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In late January, the S&P 500 was down so much (almost 10%!) that it revived talk of investors’ favorite “safe” security. No, not T-bills—and not even Amazon or Apple common stock—but the Fed “put.” Years ago, we called it the “hypothetical” Fed put. But by now, we’re believers.

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Causation between the economy and financial markets is never a clear thing. The optimistic group formerly known as “Team Transitory” believes a peak in the inflation rate is near, presumably clearing the way for even greater P/E multiple expansion than already seen in this cycle.

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We don’t profess to be professional inflation forecasters, but are struck by a sort of “temporal” mismatch in the arguments used by those who believed the inflation pick up would be temporary. Specifically, the most commonly-cited bullish inflation arguments have been secular in nature, based on long-term trends in technological innovation, demographics, and free trade.

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With consumer price inflation raging at 6.2% and few indications of an imminent rollover, Jay Powell has waved the white flag and retired the ill-begotten “transitory” descriptor. The timing of Powell’s concession is intriguing—perhaps he’s a fellow follower of a simple inflation model: the Output Gap.

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Last week we argued that U.S. money growth remains way too high to reasonably expect a peak in consumer price inflation during the next few months. At the peaks of the last five bouts of inflation of 5% or more, real growth in the M2 money supply had turned negative in four cases and had slipped to less than 1% in the other one. Today, real M2 is growing at nearly a 7% rate.

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From the start of the inflation upswing this spring, pundits cited well-known disinflationary factors they believe will soon halt the current inflationary upswing—like free trade, the speed of technological advance, and aging populations globally. 

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For those believers in a new economic- and stock-market era, there’s good news. The CPI-PPI spread has not been an effective proxy for profit margins during the 1995-to-date “New Era.” But, the failure of an inflation measure during a mostly non-inflationary era shouldn’t come as a surprise.

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It is much easier to predict inflation, itself, than to predict when investors will become traumatized by it. Some of the most helpful measures for the latter task come from the ISM Manufacturing Report. October’s readings saw three key measures above the statistical “speed limits” we calculated years ago.

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Notwithstanding the hit to consumers’ pocketbooks, it’s been amusing to follow the Fed’s recent evolution with its mindset regarding inflation. A year ago, the hope was for “symmetry”—Fed-speak for allowing inflation to run above its long-time 2% target, since it had previously undercut that level for awhile. Then, early in 2021, the word “transitory” entered the lexicon; yet months of debate and tens of thousands of utterances on financial television have clarified nothing about the Fed’s characterization of that term.

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Those in their peak earning years (40s and 50s) who’ve also enjoyed the stock market’s windfall gains are very likely to have seen their annual expenses climb much higher than the Consumer Price Index over the last several years.

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It’s been a heck of a stock market year, and there are still four months left. What else could go right? Monetary conditions, for one thing—at least as proxied by our Dow Bond Oscillator (DBO).

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