Oct

11

Every weekend I read through some classic papers from another era. With inflation expectations percolating, this weekend's reading were the many papers which pondered the failure of stocks to perform according to common sense during the inflation of the last secular cycle. (One suspects that the bear market of 2000- ? will give rise to a crop of similar articles that will provide amusement comparable to reading a Sears Roebuck catalog from the 1930s ….)

The Alpine Knock-About Fedora Hat for $0.69 and the silk ladies Clever Collar for $.29 reminds one of: R. Geske & R. Roll (J. Finance, March 1983) "The Fiscal and Monetary Linkager between Stock Returns and Inflation"

Abstract:

Contrary to economic theory and common sense, stock returns are negatively related to both expected and unexpected inflation. We argue that this puzzling empirical phenomenon does not indicate causality. Instead, stock returns are negatively related to contemporaneous changes in expected inflation because they signal a chain of events which results in a higher rate of monetary expansion. Exogenous shocks in real output, signaled by the stock market, induce changes in tax revenue, in the deficit, in Treasury borrowing and in Federal Reserve "monetization" of the increased debt. Rational bond and stock market investors realize this will happen. They adjust prices (and interest rates) accordingly and without delay.

Although expected inflation seems to have a negative effect on subsequent stock returns, this could be an empirical illusion, since a spurious causality is induced by a combination of (a) reversed adaptive inflation expectations model and (b) a reversed money growth/stock returns model. If the real interest rate is not a constant, using nominal interest proxies for expected inflation is dangerous, since small changes in real rates can cause large and opposite percentage changes in stock prices.

Finally, one notes that the real interest rate is currently -0.81% for cash, and 1.40% for the ten-year. Both are at 2-sigma lows. Where can they go but up? And is this bullish or bearish for stocks and bonds? Hmmm.

Vince Fulco writes: 

One notes the newspaper boy hat has been creeping into Minneapolis clothing trends for the last 6 months. Some guys even wearing them in the height of summer. I guess what comes next is "a chicken in every pot" meme…

Kim Zussman writes:

Checked this using BLS monthly CPI data and SP500 returns. Here is regression of stock returns vs contemporaneous CPI change:

Regression Analysis: mo ret versus chg cpi

The regression equation is mo ret = 0.00935 - 0.00906 chg cpi

Predictor Coef SE Coef T P
Constant 0.009345 0.002033 4.60 0.000
chg cpi -0.009058 0.004278 -2.12 0.035

S = 0.0419261 R-Sq = 0.6% R-Sq(adj) = 0.5%

As they say, the correlation is significant and negative (though RSQ is small and thus CPI explains little of monthly stock return).

Checked also whether this month's change in CPI predicts next month in stocks (with the usual answer, no):

Regression Analysis: M ret versus M-1 cpi chg

The regression equation is M ret = 0.00811 - 0.00503 M-1 cpi chg

Predictor Coef SE Coef T P
Constant 0.008108 0.002040 3.97 0.000
M-1 cpi chg -0.005026 0.004291 -1.17 0.242

S = 0.0420445 R-Sq = 0.2% R-Sq(adj) = 0.1%

To see how this has evolved over time, checked correlation between chg cpi and SP500 ret for non-overlapping 60-month periods:

Year corr 60 avg cpi
2010 0.12 0.18
2005 -0.17 0.22
2000 -0.04 0.20
1995 -0.25 0.24
1990 -0.15 0.33
1985 -0.22 0.44
1980 -0.12 0.71
1975 -0.32 0.55
1970 -0.18 0.35
1965 -0.07 0.10
1960 0.25 0.17
1955 0.02 0.17

As shown on the attached graph of data above, most of the negative correlation between cpi and stocks occurred in the good old days of high-cpi (70's-80's), when certain parties where whipping inflation now.

What will they whip next?


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