What the Market Wants—Inflation Stability!

Inflation stability and the trend in inflation rates matter more than the actual inflation rate itself. It is inflation stability that is a primary driver of the market performance says, Ed Easterling of Crestmont Research and author of Financial Physics. His research explains:

  • Inflation stability correlates with secular bull markets* or above average returns. (*See definition below.)
  • Inflation INstability correlates with secular bear markets* or below average returns.

Secular bull markets can make you wealthy.

Secular bear markets can make depending on your investments for retirement nearly impossible.

Easterling’s research shows that since 1900, during bull markets, stock indices (not including dividends) have risen as little as 200% (1933 to 1936) and as much as 1214% (1982 to 1999). Not bad.

During secular bear markets stock indices, not including dividends, historically fall as much as -80% (1929 to 1932) or rise 2% (1901 to 1920). Remember those numbers don’t include dividends which will help out a bit.

Inflation stability and secular bull market periods are marked by the frequency of extreme volatility, or large swings up and down are limited. Major sell-offs, such as the 1987 market crash, are met with speedy market recoveries. In fact, recoveries come to be expected. Ultimately stock indices make new highs. This leads to high confidence and allocations to “riskier assets” rise. Another consequence is that the financial service industry thrives and getting the investing part right seems easy.

Inflation stability has been the norm for the most part since 1981. The US has not seen instability in inflation rates since 1970’s. During a period of inflation INstability extreme market volatility is more common. Negative returning years are more numerous and can offset the benefits of positive return years that allow the magic of compounding to work in your favor.

So how does Easterling research differentiate inflation stability from INstability? Inflation stability exists when inflation rates trend from higher rates toward 2% or inflation stays STABLE near 2%. Inflation INstability exists when inflation rises roughly more than 1% above or below 2% in short period of time and then continues to fluctuate without up and tend without a stable trend.

Big Questions

  • Was 2007 to 2009 an inflation stability hiccup or was it the start of a new trend in prolonged inflation INstability?
  • Will the Federal Reserve be able manage the economy and inflation in a way that keeps inflation stable?
  • Do forces of inflation INstability outweigh the forces of stability?

These are meant to be long-term, big picture questions that should get you thinking. There aren’t definitive answers to these questions only educated guesses.

Make sure your professional has pondered inflation INstability as it relates to investment allocations.