Wouldn't it be great if a simple number told you whether it was safe to bet on the market going higher?
Crossing Wall Street posted a chart that suggests the stock market does very well when the monthly inflation rate is under an annualized rate of 5.3%. Conversely, the market has done poorly in months when inflation is above that 5.3% annualized level. The chart shows the the monthly return above and below that level of inflation.
The data goes back to 1871; and it is surprising how well this relationship has held up over 140 years. During this period, monthly inflation has been above the 5.3% annualized level about one-third of the time.
Historically, when inflation was below 5.3%, the stock market has had an annualized after-inflation gain of 9.59%. And when inflation was above 5.3%, then the stock market has had an annualized loss of 8.15%.
Did Inflation Cause Returns to Change?
Computers are great at finding the optimal point for a system to trade based on historical data. Technical traders call this "curve-fitting", and have learned to be wary of coincident variables being confused as causal variables. That is a fancy way of saying that the relationship between inflation levels and stock market returns might be a great way to "describe" what happened; however, it doesn't prove that the inflation level "caused" the returns to go up or down. It also doesn't prove that inflation didn't cause the returns.
Nonetheless, 140 years is a long time sample … and inflation rates affect people reasonably uniformly … and the stock market can be looked at as collective measure of the fear and greed of the population. So, using the inflation rate as a trading filter seems to be a reasonable idea worthy of further testing. What do you think?
With many market watchers expecting the inflation rate to rise, this is something to consider.