Inflation's Effect on the Stock Market: Why Good News is Bad News on Wall Street

by Mark Skousen

Inflation's Effect on the Stock Market: Why Good News is Bad News on Wall Street

By Dr. Mark Skousen, Chairman, Investment U

Monday, February 6, 2006: Issue #509

A week ago, the government reported bad news about the economy: The GDP slowed dramatically to 1.1% for the fourth quarter of 2005. And yet, the Dow Jones Industrial Average surged nearly 100 points, and bonds rallied.

Last Friday, the government reported good news: Unemployment fell to 4.7%, its lowest rate in four years, and real wages surged. Surprisingly, the Dow fell 59 points, and bonds declined.

What gives? Why is good news on the economy bad news on Wall Street? And vice versa? And what is inflation's effect on the stock market?

Some pundits blame this perversity on the bondholders. "The American economy is governed by the bond market," Louis Uchitelle writes in The New York Times. And bonds (and stocks) rally when the economy weakens (slow GDP growth), and fall when the economy strengthens (good jobs report).

Another recession may not be good for the country, but it's great for bondholders as interest rates decline and bond prices rise.

But the puzzle is much more complex than that, and the bondholders are not its biggest piece.

Inflation: The Real Culprit... and Its Effect on the Stock Market

There have been many times in the past when strong economic performance propelled higher stock prices. The 1920s, the 1950s and the 1980s are classic examples. In the Reagan years, stocks and bonds rallied sharply in response to higher economic growth rates and job creation.

In principle, the stock market should do well under conditions of strong economic growth and low inflation.

Ah, and there's the rub: inflation!

If inflation is a growing problem, investment analysts become suspicious of high economic growth or good job reports. Why? Because they fear that it reflects an inflationary boom, an artificial recovery created primarily by "easy credit" by the government, due to high federal deficits and an expanding money supply.

Under inflationary conditions, analysts do not think strong job creation and economic growth are sustainable, and the stock market falls in price because they think that the Fed will need to tighten in the future.

Or if economic growth falls, they think the Fed will ease in the future, and stocks rally. And, as I pointed out in a recent Investment U, all stock prices are forward-looking.

To a large extent, the issue hinges on the relevance of the Fed in the economy, whether the Federal Reserve engages in "easy" or "tight" money.

In other words, the Fed runs Wall Street, not the bond traders.

Is Inflation A Legitimate Fear On Wall Street and the Markets?

Charles R. Nelson, an economics professor at University of Washington, has studied the impact of price inflation, as measured by the consumer price index. He's formulated the following trading rule: "When CPI inflation is on the rise, stay out of stocks; when CPI inflation is on the decline, buy stocks."

The chart below shows the CPI inflation index since 2000:

The CPI Inflation Index since 2000

As you can see, until last year, the CPI was declining. But now, it is beginning to rise. As long as inflation is a threat, be careful about investing in U.S. stocks.

Recommendation: Better to invest in commodities and foreign stocks (as we have been recommending in our Stock Market Predictions for 2006). But when it becomes clear that inflation is subsiding, Wall Street should rally.

I'll keep you posted to determine when we can expect a fall in inflation.

Good Investing,

Mark

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