This tweet didn’t age well…
Twitter founder and former CEO Jack Dorsey sent it out in October 2021.
At the time, inflation in the U.S., as measured by the Consumer Price Index (“CPI”), was running at an annual rate of 6.2%.
Yesterday, we got news that inflation is now less than half that.
The CPI rose 3% in the 12 months ended in June.
That’s a smidge higher than average inflation rate of 2.6% over the past 10 years.
But it’s a long way from hyperinflation.
Steve Hanke at John Hopkins University is one of the world’s top experts on inflation. His data shows during the hyperinflation in Zimbabwe in 2008 the daily inflation rate hit 98%. At that pace, prices double every day.
And in Hungary in 1946, the daily inflation rate was 207%. At that pace, prices double every 15 hours.
And Dorsey’s tweet is just one example of a hardliner mentality on inflation that’s been doing the rounds.
But the numbers have proven the hardliners wrong. Inflation has gone down, not up, as supply chains return to normal and the effects of the pandemic stimulus fades.
And that’s an important signal for us as investors. Because as I’ve been showing you… falling inflation is powerful tailwind for stocks.
I’ve been banging the drum on this all year…
Here’s what I wrote in my January 30 dispatch after noting a drop in the CPI…
[If] inflation continues to slow… 2023 could end up being a very good year for the stock market.
I know that sounds crazy, given all we’ve been through… and given all the gloomy headlines.
But I hope you’ll at least stay open to the possibility that the bear market is already in the rearview mirror.
It wasn’t a popular call. We’d just been through a peak-to-trough fall of 22% for the tech-laden Nasdaq. And the S&P 500 had been through a 16% peak-to-trough fall.
But since that call, the Nasdaq is up 34% and the S&P 500 is up 17%.
Think of inflation as a “gear lever” for stocks…
A rising inflation rate sends stocks lower. A falling inflation rate sends them higher.
It’s all in the table below from Ben Carlson at Ritholtz Asset Management.
It looks at the average annual returns for the blue-chip S&P 500 between 1928 and 2020 under four different inflation scenarios – rising inflation, falling inflation, inflation at 3% or more, and inflation at 3% or less.
As you can see, when inflation was rising, the average annual return for the S&P 500 was 6.7%. But when inflation was falling – like it has been the past 12 months – the average annual return for stocks was 16.5%.
It’s a similar story when you look at the 3% inflation threshold.
When inflation was lower than 3%, the average annual return of the S&P 500 was 15.7%. When it was higher than 3%, that plunged to 6.3%.
It’s no coincidence that stocks began to peak in November 2021…
That’s when the Nasdaq hit its high and began to fall. The S&P 500 peaked two months later in January 2022.
That’s around the time the Fed started signaling it would jack up interest rates to tame inflation.
And higher rates hurt stock prices.
When rates go up, so does the “discount rate.” It’s the yield you could earn on the 10-year Treasury note if you didn’t tie up your money in stocks.
Wall Street analysts plug this into their models when they value a company’s future cash flows.
The higher the discount rate, the lower they value those cash flows.
That’s why you get this mirror relationship between the CPI and the stock market’s price-to-earnings (P/E) ratio…
The P/E ratio tells us how much investors are willing to pay for every dollar in earnings. As the CPI goes up, the P/E ratio goes down. And vice versa.
That’s a big reason stocks have been rallying…
You don’t need a Ph.D. in economics to see what I mean.
Rising inflation means interest rates go up and stock market valuations go down.
Falling inflation means lower interest rates and higher stock market valuations.
The Fed says it wants inflation in the 2% to 3% range. It’s got it there now.
That doesn’t mean we won’t get one more rate hike from the Fed. It often overshoots in one direction or the other with interest rates.
But unless we get a curveball inflation reading, the Fed is done hiking after July.
That will take pressure off stock valuations… and signal to wary investors that it’s time to get back into the market.
So, I’ll wrap up today by repeating my bullish message from the start of the year…
If inflation continues to slow, 2023 could end up being a very good year for the stock market indeed.
Regards,
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Chris Lowe
Editor, The Daily Cut