Monday, February 13, 2012

The S&P/Inflation Expectations Correlation (SPY)

A major caveat for investors trying to hedge inflation with equities: they aren't that correlated once inflation goes above 4% or so. 0-to-4% is the sweet spot. Above 4% you don't want services companies, manufacturers with tangible assets are the place to be.

This is one reason the Berlin market was able to approximate (with a 3-6 month lag) the Weimar hyper-inflation (the other being survivorship bias). The companies the historians track, the big brewers, metalworkers, miners had real assets.

Stocks of service companies without near-monopoly pricing power got crushed like any other long dated asset.
This is a point you won't see anywhere else, at least until the information contained in those dusty old german-language records gets translated.

From the Capital Spectator:
Is The New Abnormal On Its Last Legs?
The recent rise in the stock market has been accompanied by an increase in inflation expectations. That’s a healthy sign while we’re trapped in the new abnormal. One day the stock market and inflation expectations will go their separate ways, but not yet. Meantime, the economy's still struggling to break free of post-crisis gravity and so it still requires the assistance from higher inflation expectations.

As the chart below shows, the S&P 500 and the market's inflation outlook (10-year Treasury yield less its inflation-indexed counterpart) remain tightly correlated. They've been joined at the hip for several years now. That's abnormal in the long run, but for now it's still reality. The dance will end once stronger economic growth returns, and the crowd believes something approximating a normal business cycle has revived. Meanwhile, inflation and the stock market (a proxy for the overall economic outlook) are entwined.

Ed Yardeni recognizes the new abnormal in a blog post from last week:
In the past, the market’s valuation multiple tended to rise when bond yields decreased, and vice versa. In the past, rising inflationary expectations often were negative for equity valuations, while falling ones were positive. There relationships have turned topsy-turvy since early 2007, when falling yields and inflation rates started to be associated with falling rather than rising P/Es. That’s because yields and inflation rates are so low that investors fear that they may be harbingers of deflation and depression.
So why haven’t bond yields risen along with the P/E since late last year? The Fed’s Operation Twist has clearly distorted the bond market. Without it, yields would have undoubtedly risen. They still could if the program is terminated on schedule at the end of June. Meanwhile, the expected inflation rate embodied in the 10-year TIPS market has risen from a low of 1.7% on October 3 to 2.2% in early February. So far, that's been bullish for the P/E.
Scott Grannis looks at the relationship between stocks and Treasury yields directly (without adjusting for the inflation-indexed yield) and wonders if something's about to give....MORE