Inflation

Pundits could reasonably argue the market has never been more expensive in light of the prevailing rate of inflation. That’s the conclusion of the “Rule of Twenty,” which proposes that the stock market’s P/E ratio and the trailing 12-month Consumer Price Inflation rate should sum up to 20.

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What matters is whether an inflationary period is driven more by “demand pull” or “cost push.” Demand pull inflationary periods seem far more favorable than cost push periods, which, more often than not, occur in a “stagflation” macro context.

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Inflation and its potential impact on the stock market is the topic du jour, resurrecting ideas that were in vogue 30- to 40-years ago.

Steve Leuthold’s 1980 book, The Myths of Inflation and Investing, provided an exhaustive review of the evidence. But for lighter reading, more appropriate for a summer Friday, we revisit the “Rule of Twenty” developed by strategist Jim Moltz in the early 1980s.

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We’ve long considered ourselves lucky to have escaped from our graduate-economics program after only a year. Among the few nuggets we managed to retain was the startling conclusion to a paper written by a famed department professor asking, “Do Large Deficits Produce High Interest Rates?”

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It’s certain that today’s cyclical bout of inflation will prove “transitory,” if only because the word itself is practically meaningless. Our time on earth will also prove transitory, and so too will the current stock market mania—to the shock of most of the nearly 20 million “investors” on the Robinhood platform.

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Inflation is already “too high” for the current cyclical setting, and the level of inflation that equity investors are willing to tolerate will drop further as the economy recovers.

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At some point during the June/July streak of seven-consecutive S&P 500 daily-closing highs, an album from 1980 popped into our heads: Nothin’ Matters And What If It Did—released when John Mellencamp was still known as John Cougar. It brought to mind some “nothin’s” that seem not to matter.

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The refusal of the bond market to acknowledge the worsening inflation readings seems to have strengthened the consensus view that any inflation trouble will be “transitory.” Do bonds still know best when there’s a systematic, price-insensitive buyer hoovering up $120 billion of them per month? 

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Technicians are collectively bullish because of the absence of any serious internal divergences. But, severe corrections can erupt with little, or no advance warning from a deterioration in breadth and leadership. In fact, the first few years of the last bull market  provided two such examples (mid-2010 and mid-2011). 

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April ISM readings, both for Manufacturing and Services, were hot across the board. That’s good news for a still-recovering Main Street, but it manifested in ways that have frequently caused problems for a famous Street located in Lower Manhattan.

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The speculative peak for this market rally may have occurred in either January (when GameStop and other “left for dead” short candidates soared), or February (when indexes tracking the “newborns”—IPOs and SPACs—both peaked). But even if we knew that for certain, a major peak in stock prices could still be months away.

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In the latest Green Book, we noted that Producer Price Inflation does not usually become a challenge for the stock market until its annual rate breaks above 4.0%. The day that comment was published, the year-over-year gain in the March PPI for Finished Goods spiked to 6.0%, thanks mostly to the well-celebrated COVID-19 anniversary-effect. 

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The Fed’s reflationary efforts are showing up everywhere except in the measure that’s engineered specifically to minimize them—the Consumer Price Index. It’s a virtuous circle, until it is not

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The Fed has communicated it’s inflation target in uncharacteristically-plain English. Maybe they need to dumb it down more, because it’s the investors in English-speaking countries who have been the most surprised by the recent pickup in the inflation numbers!

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Inflation surprises have run hotter in the U.S. than in the rest of the world, no doubt reflecting the strength of major currencies versus the U.S. dollar. 

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When measured by the gains in stocks, gold, and house prices, there has been just one other occasion in which asset inflation was as “broad” as today—late 1980. But the differences in underlying fundamentals between then and now couldn’t be more stark. 

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Knee-jerk contrarians are already claiming the stampede in Small Cap stocks is “too consensus” to continue in the near term. We couldn’t disagree more. In fact, we are very confident that a new multi-year Small Cap leadership cycle has kicked off.

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“Don’t fight the Fed” has been great advice for stock market investors over the last nine months. For 2021, that won’t cut it. It should be: “Don’t believe the Fed.”

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We’re still coming to grips with Modern Monetary Theory and the stark realization that “the delusional is no longer marginal.”

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The big jump in Small Caps over the last two weeks has entirely reversed the segment’s summer underperformance and has technicians feverish about another “breath thrust.” Technically, it’s impressive, but we are more intrigued by the fundamental potential for continued Small Cap (and Mid Cap) outperformance.

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