Rising Inflation Makes Stocks More Attractive Than Bonds

Hypothetically, if we are earning 2.5% on a 10-year Treasury bond (IEF) and annual inflation rises to 3.0%, then our bond is producing a negative return on an inflation-adjusted basis. Thus, in a low interest rate environment, increasing inflation expectations tend to create additional demand for equities, which have a better chance of producing returns that outpace inflation.

Market Was Focusing On Inflation

Heading into the June 18 Fed statement and press conference, the market was wondering how Janet Yellen would react to rising inflation. The blurb below is from the June 17 edition of USA Today (one day before the Fed statement):

Consumer prices last month posted their sharpest increase in 15 months as inflation continued a recent acceleration from unusually low levels.

Yellen In No Rush To Raise Rates

The first clue the Fed was delivering a stock-friendly statement came as we were comparing the June 18 statement to the April 30 statement; the statements were very similar. The almost boilerplate language in the June statement meant the Fed was not going to try to "talk down" inflation expectations. From The New York Times:

Is the central bank ready to move briskly with unwinding its era of extraordinary stimulus in the economy, confident that the recovery will continue strengthening without monetary support struts? Or does the Fed expect to continue flooding the economy with cheap money well beyond the point where growth is truly robust? Ms. Yellen, less than half a year into her job leading the central bank, is already adept at saying a lot of words while conveying minimal new information. But if you read between the lines of her comments, she is clearly tilting toward the latter. She displayed no hint that her rate-increasing trigger finger was getting itchy.

Gold May Provide Some Insight

Since central banks can print new money, it is easier to increase the supply of U.S. dollars than gold (GLD). Therefore, many consider gold to be a "hard currency" or superior store of value during periods of rising inflation. In 2004, after gold completed the first step for a trend change relative to stocks by breaking above the blue trendline (see 1 in chart below), the stock market took another strong leg up, advancing 44% between mid-2004 and late 2007.

What Is Gold Telling Us Now?

Gold (IAU) has gained some ground since finding a short-term bottom on June 3. However, gold remains in a weekly downtrend relative to the S&P 500 (see chart below). Stock investors will get a probability boost if gold can complete a bullish turn relative to the S&P 500; something that has not happened yet.

Investment Implications - Anecdotal Evidence

Gold's correlation to the stock market lacks consistency. Therefore, we would classify this analysis as anecdotal evidence; helpful, but not something to exclusively guide allocation decisions. However, it is not unreasonable to assume that increasing inflation expectations could help propel stocks into a more speculative stage of this bull market, similar to 2004-2007 when the S&P 500 popped 44%. The chart of gold in isolation below (GLD) provides a guidepost for monitoring gold's progress. If GLD can close above $133.10 on a weekly basis, it would improve the odds for both gold and stocks, especially relative to bonds, looking out weeks and months.

There are things to like about gold from a "keep it on our radar" perspective, but it also remains in a weekly downtrend relative to a diversified basket of bonds. The chart below needs to flip over to the bullish camp for the Yellen-induced pop in gold and stocks scenario to bear longer-term fruit.

As noted in a recent "what could have investors done in 2008" analysis, it is important for us to wait for gold to complete bullish turns, rather than anticipating a turn. Regardless of what happens with the yellow metal, the big picture still favors the stock market bulls. Consequently, we continue to maintain exposure to stocks (SPY), and leading economic sectors (XLE). We still have exposure to bonds (TLT), but we have reduced that side of the portfolio two times over the past three weeks. As always, we will pay attention with a flexible and open mind, but Yellen's comment below about excessive risk taking aligns with the bullish case for stocks and gold:

"I don't see kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level."