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This article, by Herb Morgan, President of Efficient Market Advisors, LLC, was posted last week and was truncated due to a technical error. We are re-running this article in its entirety due to its quality and significance:

No one can deny that consumer prices have risen in the US economy, well energy prices that is. The question currently raging in the minds of portfolio managers and pundits remains. Will the price increases in energy become permanent and will the increases in energy prices be pushed through to the prices of other consumer good?

We haven't had enough full moons yet to know if the energy price hikes are temporary or permanent. We do know based upon CPI readings, which exclude energy, the temporary energy price hikes have not trickled their way down to other consumer goods. The question becomes:

Will higher energy prices eventually lead to increased prices of other consumer prices?

And

Will higher energy prices cause consumers to reduce consumption of other consumer goods?

And

Will any of these things cause stock prices to drop?

While the talking heads seem equally divided about the permanent or non permanent nature of the near $100 fill up of the family sedan, nobody seems to disagree inflation will have a negative effect on stock prices. I wonder if conventional wisdom is correct?

Please step into my spreadsheet and let's have a look:

Worst inflation (CPI ex Food & Energy NSA) years since 1979:

Year CPI S&P500 Russell 1000
1980 12.15% 32.50% 31.87%
1979 11.32% 18.61% 22.33%

Looking at the two worst inflation years since 1979 unscientifically suggests the correlation between inflation and stock prices is positive rather than negative. Your author is not advocating that inflation is good for stock prices but the numbers do cause one to challenge conventional thinking on the subject.

Let's look at some of the worst periods for stock prices and check for the presence of inflation:

Largest Non Calendar Year Drop in Stock Prices:

Drawdown CPI Russell 1000

08/00-09/02 5.2% -46.60%
08/87-11/87 1.6% -29.32%
11/80-07/82 14.9% -18.74%
06/88-08/88 0.6% -16.18%

Largest Calendar Year Drop in Stock Prices:

Calendar Year CPI Russell 1000
2002 1.92% -22.93%
2001 2.74% -13.61%
2000 2.58% - 8.54%
1981 9.54% - 5.10%
Nothing in the above data would suggest that inflation has a direct causal effect on stock prices.

Without doubt, stock prices react to earnings and the expectations of future earnings. I believe that what the stock market is telling us by its nearly flat year to date performance (-2.67% for the S&P500) is that it does not know what the future for earnings is. If the stock market could explain its actions this year it might say something like this:

It's really hard to see what the earnings are going to be. On the one hand productivity is fantastic, real estate markets are strong, interest rates are low, we just eliminated two tyrannical governments, we clearly have the upper hand on terrorists but energy prices are high. I just don't know yet if higher energy prices will hurt earnings.

Fair enough Mr. Market, lets take a look at how you reacted to higher energy prices in the past…..shall we?

Largest Increases in Oil Prices:

Year Amex Oil Index Russell 1000
2005 49.26% 1 2.69% 1
1989 36.98% 30.43%
2004 28.17% 9.49%
2003 25.91% 27.54%

1 Through September 30, 2005

Largest Drops in Oil Prices:

Year Amex Oil Index Russell 1000
2002 -14.07% -22.93%
1998 -4.66% 25.16%
2001 -3.03% -13.61%
1992 -2.96% 8.93%
In the four worst calendar years since 1989 for Oil price increases the Russell 1000 Index averaged an astonishing return of 17.53%. During the four years of the greatest drop in Oil prices the Russell 1000 Index had an average annual return of -.61%.

The bottom line is that stock markets move on earnings. In the week ended October 21, 2005, 316 companies reported earnings. Of those, 198 companies provided upside surprises to the market while only 61 disappointed analysts with their results. All of the data presented above suggest strongly that stock prices will ignore any and all bad news in the face of good earnings.

I don’t know who would win in a fight of Godzilla vs. King Kong but in the fight of Earnings vs Energy Prices expect earnings to score a decisive victory. Expect stock prices to manifest the results.

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Source: Energy Prices vs. Earnings, or Godzilla vs. King Kong