Market

Inflation And The S&P 500

In the current market, it is hard to hold the view that we are going to suffer deflation. It actually seems ridiculous to bring that up, yet only a few months ago that was the main economic argument. Many economists were calling for a Japanese-style deflationary trap that was going to be impossible to escape and that all the QE in the world (and we are still getting it) would not produce inflation. As I wrote here, inflation seemed inevitable to me. And here it is.

Not that those responsible for printing more money have admitted that more money has caused higher prices. It is of course a surprise, caused by disconnected narratives and not something caused by anyone in particular and it will, in any event, be a short-term thing. Perhaps.

In this post-post-modern world, uncertainty is an ever-increasing issue so that while inflation is everywhere to be seen, it is hard to know how much has occurred and how much is on the way. The figures are hard to believe, don’t match what we experience and are clearly heavily modified in ways convenient for the messengers.

Inflation ain’t what it used to be. It is certainly higher now by old measures than the new measures proclaim. This is not surprising because the modern economist stands by “inflation expectations” as the driver of inflation not “money supply” and it would therefore be counterproductive to push out numbers that heightened inflation expectations.

Some would say deflationists still have a leg to stand on because inflation expectations have remained low. The trouble is these expectations are derived from the very same bond yield curve that the Federal Reserve has a choke hold on, and real inflation expectations come from the Street not the cornered U.S. bond market. On the Street the shock of sudden inflation is real.

It is hard to measure inflation. For a start, it’s not the same for everyone. Working class inflation is not the same as middle class inflation and rich and super rich inflation is very different again. If a rich man’s bread doubles it’s no mind to him, but if super yachts suddenly double in price that’s a different matter. Then there is the issue of objects getting better and also cheaper and more important, as we have seen with technology. What is the inflation in communications when $1,000 wielding iPhone owners are constantly on their devices that double in power often and do way more but cost way more than the landlines they replaced?

So what is inflation now? Old measures would say it is well above 10%, but those that keep track that way also have an axe to grind.

You can’t take a loaf of bread as an example, or a car, which in my neck of the woods has gone up 500% (way more than the 360% of the official figures) in the 40 years since I first drove. Technological change has moved things a long way and made like for like just the sort of thing only a department of accountants can have a hope of making sense of.

It is interesting, however, that the smallest copper coins in common circulation around the world and through the ages have remained about the same size since the Roman Empire. Somehow when it comes to the everyday transactions, a small copper disc of similar size remains the basic unit for transaction. So maybe there is another way to gauge true inflation, which is a change of denomination rather than value.

If that little copper coin is a 1 cent or a Roman Nummis, a farthing, a 1 centimes, or 10 centimes or 10 francs debased or rebased and reminted, it is still the same little copper disc and people are still simply transacting.

So let’s look at inflation differently.

Why not think of the S&P 500 as the value of the USD economy and estimate its value versus its price to try to get a handle on “‘real” inflation.

“No, no,” folks will say, there is more added value going on in the stock market than GDP. Yet as the Fed prints, so up goes the S&P 500 and not many will suggest that when the printing stops the stock market’s ascent will keep going. Quite the opposite, many think it might crash when QE stops and crash it would if the Federal Reserve raised rates significantly or pulled cash from the system. Imagine they did both.

So let’s look at that chart:

The gap between where the long-term trend of the S&P 500 would say the U.S. economy should be and where it is today, is wide. With a heightened value, either something great must have happened to the U.S. and global economy or the premium must represent an indication of how much inflation has been injected into the system by the liquidity operations created to bridge the Covid pandemic’s economic privations. In this case, the value looks to be 1,000 points above an on trend 3,500.

Let’s look at this idea again over a longer period:

There is still the very same gap, between the long-term trend of the S&P 500 and its current post-Covid crash recovery level. To me this looks like an economy-wide measure of prices rather than value as inflation affects the value of companies in the same way as it affects other goods, and while it might not be a perfect analogue, the S&P 500 of U.S. companies are in a way a superset of all goods.

That price jump certainly isn’t because of economic progress, so what else can it be but inflation caused by more money chasing a inflexible supply of a good, in this case stocks? If that is what this is, it represents 29% inflation, a number that seems more believable than the 5% numbers being printed when inflation somehow still represents goods you can’t even buy because they are out of stock.

So is there more to come? Yes, and the key question is how much more inflation is going to be loaded into the system.

The taper is still more money to be printed and inflation to be created, and new money will have to be issued at a significant pace to fill the fiscal hole being generated at $1 trillon next year and an optimistic $750 billion in 2023. According to government projections, U.S. debt is going to be nailed 100% to GDP. You would be forgiven as seeing that as optimistic and goal setting.

Congress’s projections show a U.S. economy on thin ice, with projections certainly bullish and with little room for error.

It remains the case that the single most obvious way to escape such circumstances is to let chronic inflation grind down the real value of accumulated debts while easing the way for enterprise and the economically active.

For me the big call is, does more new money continue to pump up equities or does a slowing in the creation of new money mean money flows out of equity to make up the liquidity no longer being injected?

With the need for interest rates to stay low it certainly seems that the merry-go-round must be kept spinning and if that is the case, the downside on equities must be limited.

The price of gold suggests the deflationist still holds currency with the market and government projection certainly put a case forwards that all is under control.

So in the end you have to say “I believe” or say “I do not believe” and the latter means things won’t work out so well fiscally and more QE will have to be forthcoming and therefore inflation will keep rolling on.

So the argument now is not deflation versus inflation, but low inflation versus high inflation.

Let us remember the trend is your friend and as such I stick with my belief of a lot of more inflation to come.

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