StockWatch

We Shall Overcome

By Mark Hulbert,
Editor of the Hulbert Financial Digest, a service of MarketWatch.com

A little bit of inflation, the saying goes, is like being a little bit pregnant.

In other words, inflation inevitably feeds on itself. Once you have a little bit, a lot more is sure to come.

I predict that you’ll be hearing this saying more and more in coming months, if -- as seems increasingly to be the case -- fears of deflation continue to recede. In fact, judging by the nearly two hundred investment advisory services I monitor, the drumbeat has already started.

But, try convincing the stock market that it should always be worried about higher inflation. The historical relationship between inflation and stock prices turns out to be remarkably complicated. Except when inflation was markedly higher than it is right now, in fact, the stock market has tended to perform better when inflation is higher rather than lower.

That, at least, is the conclusion that emerged from a detailed analysis of historical data on stocks and inflation back to 1871. (The data was compiled by Yale finance professor Robert Shiller and is available at his website: http://aida.econ.yale.edu/~shiller/data.htm.)

Consider the data in the accompanying table, which reports the average monthly returns of the S&P 500 index since 1871, segregated according to inflation’s magnitude over the trailing 12 months. Notice that the correlation between inflation and stock returns is not straightforward.

When trailing 12-month inflation is...	S&P 500’s average monthly return since 1871 is...	% of months falling into this category is...
Below 0	0.61%	28%
Between 0% and 1%	0.50%	5%
Between 1% and 2%	0.40%	13%
Between 2% and 3%	0.96%	15%
Between 3% and 4%	0.53%	10%
Between 4% and 5%	-0.23%	6%
Above 5%	-0.05%	22%

For example, the sweet spot for the stock market, at least historically, has been when annual inflation over the trailing 12 months has been in the range of 2 - 3 percent. During such months, the S&P 500 has produced an average return of a littler less than 1 percent, more than double its long-term historical average of approximately 0.4 percent per month.

To put this in context in relationship to where we stand today, bear in mind that the CPI over the last 12 months rose by 1.5 percent -- and that the core rate, excluding food and energy, rose by 0.8 percent. So, inflation could, essentially, double from where it stands currently without leading the judgment of history to a bearish conclusion about stocks.

None of this is to say that inflation is necessarily a good thing, of course. My point in presenting this historical data is, instead, to provide a reality check for those who take it for granted that it would be automatically bad for stocks if inflation were to heat up.