Friday, February 11, 2011

Reason #85 Why Investors Should Worry About The Inflation/Deflation Debate

OK, the title of this post is a little facetious, but there are obviously lots of reasons that all investors should focus on which direction prices are heading.

But here's one that you might not have thought about.

In a deflationary world (e.g. Japan for the last two decades) the direction of bond yields and stock prices move in the same direction. That is, if interest rates move higher, stock prices tend to go up as well.

On the other hand, in an inflationary environment (e.g. the U.S. during the 1970's), bond yields and stocks move in opposite directions. Rising interest rates lead to falling stock prices in periods of inflation.

There are several reasons for this, but the overwhelming explanation has to do with the direction of the economy during times of inflation or deflation.

Inflation usually happens when economic growth is robust, and there is more demand than supply, while deflation occurs in the opposite environment.

Recent data from Ned Davis Research confirms that we have been living in a deflationary world in the United States over the past few years.

Joseph Kalish, who is a senior macro strategist at Ned Davis, wrote yesterday that the 12-month correlation between Treasury bond returns and equity returns has:

..reached an extreme level, falling to its most negative reading since November 2002. Since 1927, the only other time the correlation was more negative was in 1956. From a historical perspective, this condition won't last much longer.

Mr. Kalish goes on to note:

Over the past 35 years, when the 3-month rate of change of the bond/stock ratio has fallen 6.6% or more, long-term Treasury bond prices have fallen at a 14.0% annual rate.

If you believe - as I do - that we will remain in a deflationary environment, further selling pressures in the bond market will lead to continued gains on stocks.

On the other hand, if you believe that we are edging closer to the time when inflation will be a more important factor in our economy (as Ned Davis Research does), we may see a divergence between stock and bond market movements, as well as more volatility.