The stock market is not a bad place if high U.S. inflation is more than transient. Nor is it a bad place if the recent rise in inflation turns out to be merely temporary.
This relationship between actions and inflation is comforting, because the current debate on inflation remains unresolved as never before. Although the most recent U.S. inflation data showed that the consumer price index in July had retreated slightly since June, the 12-month rate of change still stands at 20-year highs. .
Think of the performance of a hypothetical portfolio built by Nicholas Rabener, founder and CEO of FactorResearch in London. The portfolio contained 5% of the stocks that, at one point, had the highest final correlation of five years with the U.S. 10-year equilibrium inflation rate. This rate is equal to the difference in yields between the U.S. Treasury at 10 years TMUBMUSD10Y,
and 10-year TIPS; represents the bond market’s bet on what inflation will be over the next decade.
The following graph shows that this hypothetical portfolio was highly correlated with the Russell 2000 RUT index,
a benchmark for the small and medium capitalization sectors of the US stock market. That is, when an unexpected rise in inflation occurs, the most inflation-sensitive stocks do, on average, do nothing better or worse than a broad index fund.
This is good news, as it means you won’t have to get out of your way to find the handful of stocks most likely to work better if inflation goes up even more. A Russell 2000 index fund, such as the iShares Russell 2000 ETF IWM,
he should do just as well, assuming the future is like the past.
What if higher inflation is transient? The lesson of the chart is that a Russell 2000 index should also work well.
By the way, Rabener stressed in an email that the analysis focused only on the last two decades, of which data on the unequal inflation rate exist. After focusing on CPI changes in the late 1940s, he found that certain sectors – particularly energy – outperformed the market when inflation was high. However, he added, this knowledge “has only limited practical value, as investors are not particularly adept at forecasting inflation.”
Value and growth when inflation is high
I came to similar conclusions when analyzing growth and value stocks in high and low inflation environments. This is surprising, as the widespread narrative on Wall Street is that stocks of value are the ideal place to warm inflation.
This narrative is wrong, as I reported in a June 2021 column, because there is an inconsistent correlation between the relative performance of value stocks and the final 12-month change in the CPI. Yes, the relative strength of value versus growth has been positively correlated with inflation at times; this last year has been one of those occasions.
However, there have been other times when the opposite has happened. Perhaps the most spectacular example came in the wake of the bursting of the Internet bubble, when inflation expectations fell sharply and value far outstripped growth. In fact, value outpaced growth in the early 2000s more than in any other multi-year period of the last century.
The conclusion? We have even more evidence of the famous stock market efficiency. It does remarkable work that reflects all the information that investors collectively have at all times. When you or I read the headlines of inflation, this reality has long been reflected in stock prices. We do not gain any advantage over the market by switching in or out of stock values after reading these headlines.
Mark Hulbert regularly contributes to MarketWatch. His Hulbert Ratings keeps track of investment bulletins that pay a fixed fee to be audited. You can contact him at [email protected]
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