Inflation—a general rise in the price of goods and services in an economy—can be problematic for the stock market for various reasons. Not only do input prices go up, which can crimp corporate profits, but consumers lose purchasing power if wages don’t also rise, leading to slower spending in the economy. And then there’s monetary policy. Higher rates meant to cut down inflation also tend to hurt stock valuations, meaning stock prices go down.

So, in a nutshell, inflation is bad. But how do we know when inflation is so bad that it hurts stock prices?

Our featured indicator above attempts to quantify the relationship between inflation and stock prices. On the top clip of the chart, we have the monthly performance of the Dow Jones Industrial Average. Also known as just “the Dow,” this is what most people likely think of when they hear the words “the stock market.” In the bottom clip, we have two lines. The first, the orange line, shows the year-to-year change in the Consumer Price Index (CPI). The CPI is a commonly watched measure of the changes in prices that an average American consumer experiences. The second line, the blue dashed one, shows the 6-month average of the orange line.

This 6-month average of the annual inflation rate is the reference point for this indicator. For example, when the annual rate of inflation (orange line) falls below the 6-month average (blue dashed line), the indicator triggers a buy signal for the Dow. But, when the annual inflation rate crosses above the 6-month average by 0.6% or more, it triggers a sell signal.

Historically, going back to 1965, the Dow has returned about 6.5% per year, on average. If you had followed the buy and sell signals generated from this indicator, however, you would have averaged a return of nearly 9% per year. Of the roughly 40 signals during this period, 70% of them produced a profitable outcome. Not bad.

This indicator is one of the six indicators used in the inflation component of our primary stock market risk model. It adds some diversity to the mix by measuring the annual inflation rate against its recent (6-month) history, which gives us a sense of how much inflation is accelerating or decelerating.

As evidenced by this year, measuring inflation is important when managing money. The latest sell signal from this indicator came in the first quarter of 2021 when it looked like inflation was finally starting to really accelerate to the upside. The Dow was at a level of 32,982 when that sell signal was generated, and, as of this writing, the Dow is trading below 30,000. A good call.

 

This is intended for informational purposes only and should not be used as the primary basis for an investment decision.  Consult an advisor for your personal situation.

Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.

Past performance does not guarantee future results.