Research.LeutholdGroup

Notwithstanding the hit to consumers’ pocketbooks, it’s been amusing to follow the Fed’s recent evolution with its mindset regarding inflation. A year ago, the hope was for “symmetry”—Fed-speak for allowing inflation to run above its long-time 2% target, since it had previously undercut that level for awhile. Then, early in 2021, the word “transitory” entered the lexicon; yet months of debate and tens of thousands of utterances on financial television have clarified nothing about the Fed’s characterization of that term.

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Those in their peak earning years (40s and 50s) who’ve also enjoyed the stock market’s windfall gains are very likely to have seen their annual expenses climb much higher than the Consumer Price Index over the last several years.

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It’s been a heck of a stock market year, and there are still four months left. What else could go right? Monetary conditions, for one thing—at least as proxied by our Dow Bond Oscillator (DBO).

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Pundits could reasonably argue the market has never been more expensive in light of the prevailing rate of inflation. That’s the conclusion of the “Rule of Twenty,” which proposes that the stock market’s P/E ratio and the trailing 12-month Consumer Price Inflation rate should sum up to 20.

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What matters is whether an inflationary period is driven more by “demand pull” or “cost push.” Demand pull inflationary periods seem far more favorable than cost push periods, which, more often than not, occur in a “stagflation” macro context.

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Inflation and its potential impact on the stock market is the topic du jour, resurrecting ideas that were in vogue 30- to 40-years ago.

Steve Leuthold’s 1980 book, The Myths of Inflation and Investing, provided an exhaustive review of the evidence. But for lighter reading, more appropriate for a summer Friday, we revisit the “Rule of Twenty” developed by strategist Jim Moltz in the early 1980s.

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We’ve long considered ourselves lucky to have escaped from our graduate-economics program after only a year. Among the few nuggets we managed to retain was the startling conclusion to a paper written by a famed department professor asking, “Do Large Deficits Produce High Interest Rates?”

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It’s certain that today’s cyclical bout of inflation will prove “transitory,” if only because the word itself is practically meaningless. Our time on earth will also prove transitory, and so too will the current stock market mania—to the shock of most of the nearly 20 million “investors” on the Robinhood platform.

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Inflation is already “too high” for the current cyclical setting, and the level of inflation that equity investors are willing to tolerate will drop further as the economy recovers.

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At some point during the June/July streak of seven-consecutive S&P 500 daily-closing highs, an album from 1980 popped into our heads: Nothin’ Matters And What If It Did—released when John Mellencamp was still known as John Cougar. It brought to mind some “nothin’s” that seem not to matter.

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The refusal of the bond market to acknowledge the worsening inflation readings seems to have strengthened the consensus view that any inflation trouble will be “transitory.” Do bonds still know best when there’s a systematic, price-insensitive buyer hoovering up $120 billion of them per month? 

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Technicians are collectively bullish because of the absence of any serious internal divergences. But, severe corrections can erupt with little, or no advance warning from a deterioration in breadth and leadership. In fact, the first few years of the last bull market  provided two such examples (mid-2010 and mid-2011). 

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April ISM readings, both for Manufacturing and Services, were hot across the board. That’s good news for a still-recovering Main Street, but it manifested in ways that have frequently caused problems for a famous Street located in Lower Manhattan.

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The speculative peak for this market rally may have occurred in either January (when GameStop and other “left for dead” short candidates soared), or February (when indexes tracking the “newborns”—IPOs and SPACs—both peaked). But even if we knew that for certain, a major peak in stock prices could still be months away.

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In the latest Green Book, we noted that Producer Price Inflation does not usually become a challenge for the stock market until its annual rate breaks above 4.0%. The day that comment was published, the year-over-year gain in the March PPI for Finished Goods spiked to 6.0%, thanks mostly to the well-celebrated COVID-19 anniversary-effect. 

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The Fed’s reflationary efforts are showing up everywhere except in the measure that’s engineered specifically to minimize them—the Consumer Price Index. It’s a virtuous circle, until it is not

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The Fed has communicated it’s inflation target in uncharacteristically-plain English. Maybe they need to dumb it down more, because it’s the investors in English-speaking countries who have been the most surprised by the recent pickup in the inflation numbers!

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Inflation surprises have run hotter in the U.S. than in the rest of the world, no doubt reflecting the strength of major currencies versus the U.S. dollar. 

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When measured by the gains in stocks, gold, and house prices, there has been just one other occasion in which asset inflation was as “broad” as today—late 1980. But the differences in underlying fundamentals between then and now couldn’t be more stark. 

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Knee-jerk contrarians are already claiming the stampede in Small Cap stocks is “too consensus” to continue in the near term. We couldn’t disagree more. In fact, we are very confident that a new multi-year Small Cap leadership cycle has kicked off.

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“Don’t fight the Fed” has been great advice for stock market investors over the last nine months. For 2021, that won’t cut it. It should be: “Don’t believe the Fed.”

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We’re still coming to grips with Modern Monetary Theory and the stark realization that “the delusional is no longer marginal.”

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The big jump in Small Caps over the last two weeks has entirely reversed the segment’s summer underperformance and has technicians feverish about another “breath thrust.” Technically, it’s impressive, but we are more intrigued by the fundamental potential for continued Small Cap (and Mid Cap) outperformance.

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Long before policymakers’ extreme response to the COVID collapse, we feared that the Fed’s interventions were suppressing important signals from the stock and bond markets. But we now suspect that hyper-expansionary policies are suppressing price signals from the “real” economy as well.

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The Fed is hell-bent on generating inflation of 2% or higher in an over-supplied world that we think should probably be experiencing mild deflation. Their success or failure at this mission will be critical for asset allocators. For equity managers who must remain fully invested, however, the more important question might be not whether the Fed can generate higher inflation, but where.

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Where inflation goes next will be primarily determined by the probability of a recession.

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In the aftermath of the Great Financial Crisis, we reminded investors that it would be historically unusual for the thematic leaders of a bull market to repeat as the winners of the subsequent bull.

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Two words sum up the past decade pretty nicely: U.S. Exceptionalism. The superiority of U.S. assets really comes down to the unique combination of growth (U.S. stocks), yield (U.S. bonds), and relative safety (both U.S. stocks and bonds).

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We put together an Inflation Scorecard that monitors two critical sets of inflation drivers: demand pull and cost push. The qualitatively-adjusted score is much closer to a neutral reading than the mechanical composite (which suggested quite a bit more disinflationary headwind).

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Just a few months ago, Fed Chairman Jerome Powell boasted a reputation as a straight-talking, sound-money banker.

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Wage inflation should accelerate in the months ahead, oil could bounce from its oversold low, and college textbooks might double in price before the fall semester. No problem…

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The latest CPI numbers missed market expectations. The problem is not with the actual CPI numbers, but merely the fact that market expectations are still a tad too high. More disconcerting is the cool trend in housing inflation.

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The year-over-year headline number was in line with market expectations but the month-over-month increase missed market consensus (0.1% vs. 0.2% expected). All else being equal, there is a good chance CPI might have peaked for 2018. A stronger dollar is disinflationary while the short term impact of tariffs is higher import prices.

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After yet another benign figure on wages for June, the idea that inflationary pressures might be a problem for the stock market seems far-fetched.

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Headline and Core CPI figures hit estimates right on the nose in May, continuing the trend of modest but not outrageous price increases. Energy prices have boosted headline CPI while core CPI continues to be driven by services. With both of the Fed’s mandates pretty much accomplished, appreciate this rare window of time.

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Consumer Staples has historically been the sector most resistant to intermediate stock market corrections, exhibiting an average “downside capture” of less than 40% during all such declines dating back to 1989.

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The first quarter S&P 500 earnings “beat” rate stands to be the highest in history, as any CEO with a pulse has learned to lower the hurdle.

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For the first time in this bull market, defensive stocks failed to provide any semblance of defense during a market correction.

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The setback that began in late January qualifies as the sixth intermediate correction of the current bull market, where “intermediate” is defined as an S&P 500 loss ranging between 7%-12%...

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The headline and Core CPI numbers for January both came in hotter than expected. Despite the resurrected interest and concerns about inflation we still haven’t caught inflation fever. Because of the narrative (correct or not) look for increased volatility surrounding inflation announcements.

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