The Stock Market's Dilemma with Inflation

With the massive collapse in bond prices, and the consequential rise in rates, all due to the potential for ratings downgrades, due to the nonstop printing of money, some pretty savvy people are preparing for a big bout of inflation.

So what does that mean for the stock market? Well, it’s not as bad as you might think, if you’re a bull. If the Fed encourages inflation, and then does nothing to stop it, stock prices can actually rise … a lot. The problem is that your buying power can get eroded from inflation faster than you make money from the increase in stock prices. What happened in Zimbabwe is an extreme example, as it has had one of the best performing stock markets on earth, rallying thousands of percents in a month! The problem is that the cost of living was going up even faster.

The dilemma with inflation, at least from a strict stock-market-direction perspective, is when the monetary authorities decide to shut the spigot and reverse the inflationary printing of money, the result is usually quite bad for the market. That’s what happened in the U.S. at the end of the 1970s/early 1980s. When the Fed sees signs of inflation, who knows what they’re going to do with respect to reining in all the money they’ve created. Heck, according to this Reuters article, the Fed thinks authorities need to start planning now what they’re going to do when inflation returns. Start planning now? That confirms it; they really are making this up as they go.

Me personally? I think that there’s still a pretty good battle going on between the inflationary effects of the global printing of money and the deflationary effects of the persistent collapse in real estate prices. Who is going to win is still an unanswered question, although John Paulson’s bet seems to be that the global quantitative easing is going to win out.

Comments

[Dave Wrixon:]

Why invest in the US at all when there are plenty of other places offering much higher potential returns at much lower risk?

Isn't it the fact that US investment has tailed-off dramatically that has precipitated the crisis in the first place. The economy was effectively hollowed out by consumers being given access to the collateral underpinning the economy.

May 24 03:08 AM

[Tom Wright:]

I would be wary of devoting too much to international investments until I had some idea of how much of American consumption has now (gasp!) turned into a desire to save. Can large economies (India and China) create enough internal demand for products to overcome their losses from America's reduction in purchases of their exports?

May 24 10:11 AM

[cameroni:]

The key for me is the actions and reactions of state and municipal governments. While the Fed may be intent on defacto currency destruction through stimulus efforts and borrowing, local and state governments still need to balance the books. This is where the system will fall apart if QE fails which it will.

The result will be severe curtailing of services at all levels, shrinking public employment roles as taxes rise and become more difficult to collect, increased tax sales of property to raise revenues and a public service parsed of all but the most essential of servants.

We have more than enough deflationary steam ahead of us yet. Inflation (dollar devaluation) is already here too though. Some call it a perfect storm. We will have an inflationary depression.

Throw in high interest rates an you could choke off a substantial amount of economic activity. I don't think Bernake and Paulson lack imagination. They just don't have many options left to work with.

Cam

May 24 06:07 PM