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Two words that strike fear into the hearts of investors.
Are such fears justified? Let’s take a look…
If we segment calendar year changes in the Consumer Price Index (CPI) into quintiles, we observe the following:
Source Data for all tables herein: YCharts, BLS, Stern.NYU.edu/~adamodar
During years with the highest inflation (quintile 5):
During years with the lowest inflation (quintile 1):
What’s left? The so-called “goldilocks” periods in which inflation was running neither too cold nor too hot (in a range between 1.2% and 4.7%). It was during these quintiles that stocks posted their best returns on both a nominal and real basis.
The “goldilocks” periods (quintiles 2-4) also contained fewer recessions and consequently a higher percentage of years in which stocks finished higher.
Which quintile are we in today?
With the CPI up 2.1% over the past year, we are right on the border of quintile 2 and quintile 3. While fears of inflation seem to be picking up in recent weeks, we’re still much closer to a deflationary environment than an inflationary one. And things can change rather quickly: CPI was 4.1% in 2007 before the 2008 deflationary collapse.
Source Data: St. Louis Fed (FRED).
The Federal Reserve seems to be of this opinion as well, with the Effective Fed Funds Rate of 1.42% still below inflation and far below its historical average of 4.86%.
Source Data: St. Louis Fed (FRED).
Does that mean stocks can’t go down as long as inflation stays where it is?
No. While the “goldilocks” quintiles have historically shown higher returns and more positive years than inflationary/deflationary regimes, there are a number of exceptions. Most recently, stocks declined in 2000 (-9.2%), 2001 (-11.9%), and 2002 (22.1%) with CPI registering 3.4%, 1.6%, and 2.5% during those years. With the exact same inflation numbers in 1995 (2.5%), 1996 (3.4%), and 1998 (1.6%) stocks finished higher by 37.6%, 23%, and 28.6%.
Which should tell you that the level of inflation is only one of many factors influencing equity returns. Much more important to short-term returns is sentiment (how much investors are willing to pay for a given level of earnings) and to long-term returns is valuation (how much investors are paying today relative to history).
Even if you were able to predict the level of inflation next year with precision, it would be impossible to use that figure in predicting the return of the stock market.
Perhaps there are more important things for investors to worry about.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.
In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.
You can follow Charlie on twitter here.
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The information herein was obtained from various sources. Pension Partners does not guarantee the accuracy or completeness of such information provided by third parties. The information given is as of the date indicated and believed to be reliable. Pension Partners assumes no obligation to update this information, or to advise on further developments relating to it.
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The Standard & Poor’s 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
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