Using the Inflation Rate as a Trading Filter

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.

110522 Stock Market Returns and 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.
 
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0 Comments
  1. trading style is devoted exclusively to scalping, or carving out small chunks of price movement in a broader trend. As a scalper, I try to limit the parameters and variables that traders with longer investment horizons must take into consideration. In short, I am interested in momentum and, more specifically, price action. Renko charts are unique in that they deal only with price; there is no consideration is given to volume or time.

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