Economy and Environment

BULLS & BEARS: Slowing inflation may mean good news ahead for stocks

November 28, 2005

Despite natural disasters, war and oil shocks, the U.S. economy has had a good year, with the gross domestic product posting growth of 3.8 percent. Corporate profits will grow this year at a doubledigit rate.

And yet the U.S. stock market, as measured by the Dow Jones industrials, has done next to nothing. Here's one big reason: fear of inflation. It's slowed the economic sprint and caused investors to reach for their worry beads.

We all know Alan Greenspan has been concerned about the big "I" and has been doing his best to tame it by ratcheting up rates.

Even so, the Bureau of Labor Statistics says the Consumer Price Index has increased 4.3 percent year over year.

Earlier this year, the trailing CPI was at 5 percent and last month it was 4.7 percent. So it looks as though the good doctor's medicine may be doing the trick and lowering the CPI's temperature.

The Leuthold Group recently published a study that compared, quarter by quarter, 79 years of stock market performance with inflation. Much of the study reinforces what you might expect. Stocks do best with just a little inflation or a little deflation. As inflation increases into the high single digits, stock market returns get lower and lower. No surprise there. And when inflation really soared into the double digits, the stock market had negative returns. Again, no surprise. The most interesting part of the study, however, looks at how stocks respond to the directional changes in the CPI readings. Such as, what has happened to stocks when inflation decelerates; like, what is happening now?

During periods when inflation decelerates, even just by a fraction, the stock market has historically zoomed up more than 15 percent over the next year.

The study concludes that "the best environment for stocks appears to be decelerating inflation pressures."

Another phenomenon that occurs during deceleration is that price-to-earnings ratios expand.

Maximum P/E ratios historically have been achieved when inflation decelerated a smidgen, too.

During the past "best environments," the S&P 500's P/E averaged about 19 times earnings following a one-year period of decelerating inflation.

If you were to use this historical data and apply it to today, what would the "decelerating inflation" crystal ball tell us?

The current S&P 500 forward earnings-per-share estimate is $85.10; multiply that by a P/E of 19 and you get an S&P 500 index at 1,616.

If the S&P were at 1,616, the Dow Jones industrials would be just under 14,000, or 30 percent higher than today.

I know a market at 14,000 sounds like "irrational exuberance," but if the deceleration in the CPI continues, those results would be no big deal in the history books.



Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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