Last week, we began the process of overviewing the big-picture macro drivers of the stock market as we explored the state of the economy and expectations for earnings. The bottom line take was the economy appears to be doing just fine, thank you, and the consensus for earnings growth this year looks strong - as in, very strong.

To be sure, there has been a fair amount of news and volatility since that post. And it would be logical to address what is happening with all the geopolitical issues, market breadth, the state of the AI trade, etc. However, so far at least, nothing has happened to impact the primary trend of the market. As such, I think it best to continue with our overview of the macro drivers.

Since we covered the economy and earnings last week, we've still got the topics of Inflation, the Fed/Monetary Policy/Rates, and Valuations to review. So, let's get to it...

The Definition of Inflation

According to the Federal Reserve: "Inflation is the increase in the prices of goods and services over time... a general increase in the overall price level of the goods and services in the economy."

Investopedia and standard textbooks say inflation is "a gradual loss of purchasing power that is reflected in a broad rise in prices for goods and services over time."

The International Monetary Fund (IMF) says, "Inflation is the rate of increase in prices over a given period of time... how much more expensive a set of goods and services has become."

Or, as I recall from my very first Econ class a lifetime ago, inflation is "too many dollars chasing too few goods."

All Eyes

There can be little argument that inflation has been a focal point of the Federal Reserve, politicians, consumers, and the markets for several years now. Unless you've been living under a rock, you likely know that inflation soared after the COVID crisis on the back of the government dropping trillions of dollars into people's checking accounts and manufacturing supply chains going haywire.

The result was the fear that the U.S. was about to revisit the 1970's inflation nightmare where the Fed eventually won the war but almost killed economy in the process. And with the CPI (Consumer Price Index) approaching double digits in early 2022, one couldn't be blamed for worrying.

However, as COVID fell away and supply chains adjusted, so too did the rate of inflation. And by early 2024, the CPI was close to levels seen before face-coverings became a fashion statement. The question, of course, is if the spike in inflation is now "whipped."

While it is hard to predict pricing policy of corporate America and consumer behavior, which ultimately drives the rate of inflation, it is possible to model the components of the CPI and the historical causes of inflation.

The Inflation Model

Not surprisingly, the folks at Ned Davis Research Group have done just that. In short, yes, there is a model for that. See below...

View Larger Chart
Copyright Ned Davis Research Group, All Rights Reserved

The top clip is the Consumer Price Index, aka the rate of inflation. The bottom clip is NDR's Inflation Timing Model.

Interpreting the model is pretty straightforward. For me, when the model's blue line crosses above 0, it means inflation is likely on the rise. And when the model reading is above 10, history shows that inflation has basically been well above normal.

Note the red box that I've drawn around the CPI from late 2020 through early 2022. In short, the model did a fine job of alerting us that inflation was on the rise and about to get nasty.

The model also did an excellent job with the opposite situation in the fall of 2022. The bottom line here is that while everyone was still fretting mightily about what inflation was going to do next, the model said inflation would decline. Nice.

And decline it did until late 2024/early 2025 when the model warned that inflation was no longer heading in the right direction. However, that warning signal turned out to be short-lived as the model moved back below the zero line at the end of 2025.

The good news is that recent data has confirmed the model's reading as prices have largely been better behaved of late. And the rate of inflation is back under 3%.

Is 3% the New 2%?

The bears are quick to argue with my relatively sanguine view of inflation by reminding us that the rate of inflation is still well above the Fed's stated target of 2%. Therefore, our furry friends contend that the Fed is not likely to be "friendly" any time soon.

While this argument makes sense, it is important to remember that (a) the Fed has a dual mandate and (b) the Fed's measure of inflation (Core PCE) differs from the definition most often cited in the popular press.

The key here is that the Fed is not focused only in inflation. No, the Fed must also strive to keep the jobs market healthy. As such, the FOMC needs to walk a tightrope between the rate of inflation and the state of the economy.

So, the Fed has been cutting rates while inflation remains above their target because the labor market has been weakening. The bulls have celebrated the moves as everybody knows that it doesn't pay to "fight the Fed." So, with the Fed cutting rates, investors have sided with the bulls.

However, it is important to note that the Fed is NOT "on a mission here." Jay Powell and his merry band of central bankers are NOT trying to perk up the economy. No, they are merely trying to return rates to a more "normal" level so that there is balance between the rate of inflation and the jobs market.

So... The thinking is the Fed will "let things run hot" (I.E. inflation above the 2% target) for a while as they work to stabilize the jobs market. Thus, one could argue that 3% inflation is fine - for now.

The Bottom Line

The good news is history shows that a little inflation tends to be a good thing. Good for stock prices. Good for the value of your home. Good for earnings, etc.

Therefore, my take is that inflation does NOT present a problem for the stock market at this time. While I don't agree that this is a "don't fight the Fed" situation, I will opine that the Fed not in an antagonistic stance here. As such, I'm of the mind that investors should stay seated on the bull train. For now, of course.

Thought for the Day:

Every minute you are angry you lose 60 seconds of happiness. -Unknown

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research, a Registered Investment Advisor

Disclosures

At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None - Note that positions may change at any time.

NOT INDIVIDUAL INVESTMENT ADVICE. IMPORTANT FURTHER DISCLOSURES