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The stock market is not a bad place if high US inflation is more than transient. It’s also not a bad place if the recent spike in inflation turns out to be just temporary.
This relationship between stocks and inflation is heartwarming, as the current inflation debate remains unresolved as ever. Even though the most recent inflation data in the United States showed that the consumer price index in July was down slightly from June, its 12-month rate of change is still at a high in 20 years.
Consider the performance of a hypothetical portfolio built by Nicholas Rabener, Founder and CEO of FactorResearch in London. The portfolio contained the 5% of stocks that at one point had the highest five-year correlation with the 10-year breakeven US inflation. This rate is equal to the difference in yield between the 10-year US Treasury TMUBMUSD10Y,
and ADVICE over 10 years; it represents the bond market’s bet on what inflation will be over the next decade.
The graph below shows that this hypothetical portfolio was highly correlated with the Russell 2000 RUT index,
a benchmark for the small and mid-cap sectors of the US stock market. This means that when there is an unexpected rise in inflation, the most inflation-sensitive stocks on average do no better or worse than a large index fund.
This is good news because it means you don’t have to do all you can to find the handful of stocks that are most likely to perform best if inflation rises even higher. A Russell 2000 index fund, such as the iShares Russell 2000 ETF IWM,
should do as well, assuming the future is like the past.
What if the rise in inflation was transient? The lesson from the chart is that a Russell 2000 index should also perform well.
True, Rabener pointed out in an email, his analysis focused only on the past two decades, for which data exists for breakeven inflation. Focusing instead on changes in the CPI until the late 1940s, he found that certain sectors, notably energy, outperformed the market when inflation was high. However, he added, this knowledge is “of limited practical value because investors are not particularly skilled at forecasting inflation.”
Value and growth when inflation is high
I have drawn similar conclusions when analyzing growth and value stocks in environments of high and low inflation. This is surprising, because the widespread narrative on Wall Street is that value stocks are the place to be when inflation heats up.
This narrative is wrong, as I pointed out in a June 2021 column, because there is an inconsistent correlation between the relative performance of value stocks and the 12-month change in the CPI. Yes, the relative strength of value over growth has sometimes been positively correlated with inflation; last year was one of those occasions.
Yet there have been other times when just the opposite has been the case. Perhaps the most dramatic example came in the wake of the dot-com bubble burst, when inflation expectations fell dramatically and value outpaced growth dramatically. In fact, value outpaced growth in the early 2000s by more than any other multi-year period in the past century.
The bottom line? We still have proof of the famous efficiency of the stock market. It does a remarkable job of reflecting all the information collectively available to investors at any given time. As you or I read the headlines about inflation, that reality has long been reflected in stock prices. We do not gain any advantage in the market by switching to or exiting value stocks after reading these headlines.
Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment bulletins that pay a fixed fee to be audited. He can be contacted at [email protected]
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