Look to the Markets to Assess Inflation

To assess inflation, you don’t have to rely upon flawed government numbers, like CPI or PPI. All you need to do is look to the markets and see that oil, copper, platinum, wheat, and gold are breaking to new highs almost every day. Inflation is ever present, and despite the recent bounce in equity prices, at some point these inflationary pressures are likely to take a bite out of equity prices.

I avoid the government inflation noise and create my own inflation indicator from the price trends in crude oil, gold, and yields on the 10 year Treasury bond. I let the markets tell the story. With gold and crude oil surging this past week and with yields starting to move higher, inflation pressures are mounting, and typically, this a strong headwind for higher equity prices.

The Indicator

My inflation indicator is shown in figure 1 below, a weekly chart of the S&P 500 (SPY) [click both images to enlarge].

The indicator is constructed by looking at the strength and quality of the price trends in gold, crude oil and yields on the 10 year Treasury bond. To assess the trend, I look at the current price relative to past pivot points and trend lines formed by those pivot points. For example, a breakout over two pivot points would constitute a higher trending market.

The Study

Now let's return to figure 1 and our inflation indicator. We can see that the current value is in the danger zone indicating high levels of inflation, and the question then becomes: what does this mean for equity prices?

So let's design a study where we buy the S&P 500 when the indicator reaches the danger zone, and we will sell our position when the indicator moves out of the danger zone. Very simple.

Since 1984, there have been 49 unique instances where the indicator has been in the high inflation or danger zone. If you were so smart to only buy the S&P500 during these periods, such a strategy would yield a negative 307 S&P 500 points with 47% of your trades being winners. The equity curve for this strategy is shown in figure 2, and it should be obvious that being in the market when inflation is high (as defined by the indicator) is not a good strategy. Since 1984, there really is no single period where there is an edge to being in stocks when the trends in gold, crude oil, and Treasury yields are strong.

Or to spin another way: strength in gold and crude oil and higher Treasury yields really does make a difference for equity prices.

The bottom line is this: high inflation, as determined by this indicator, is a significant head wind for higher equity prices. Although I remain bullish on equities as investor sentiment is bearish, I must recognize that the inflation genie is out of the bottle, and this will likely limit the sustainability of any price advance.

Comments

[insideoil]

Simply add the thought that oil at $100/bbl today is the same value arguably as oil at $60/bbl, based on old exchange rates US$/Euro. The conclusion then is that it will be US equities that have a problem, not the rest of the world- as it is only the US (and US peg countries) really seeing the inflation.
Maybe you could do the same analysis, but from the perspective of the Euro ? I for one would be most intrigued to the outcome.
Perhaps also add to this the inflationary impact all those extra petrodollars will have - unless GCC/Opec players switch to Euro's or a basket of currencies.
So many options - so little time !!!

[Pauly B]

If the Fed cuts again we should all be paying $4.00 to $4.50 a gallon this summer at the pump and the average cost for each grocery item we put into our cart should be well above $2.25 a item. Some dismiss food and energy in the inflation calculation but when I go to pay for the item I put the calculation back in my inflation indicator!

[cheesecake]

i stopped buying tomatoe's about 2 years ago, when they hit $1 per tomato. milk, packaged and sliced meats have also gone up since then. basically, inflation really started mid 2005, probably linked to the reckless housing prices.

[sbenard]

I'm just curious if your inflation indicator has had code programmed for Tradestation. I'd like to take a closer look at it with my other indicators.