Inflation

Inflation is the price movement of goods and services in an economy.

Inflation has a direct influence on the stock market. While looking at inflation can be still subjective to the trader, a little history can explain what the effect inflation has had in the stock market's past.

Between 1970-1980 there was high inflationary trend. During this period, as inflation was rising and "not in control," the trend was for businesses and individuals to increase debt load. The rationale was to borrow today with more valuable dollars and pay off the debt in the future with less valuable dollars. While this concept is sound in a situation with up-trending inflation, the problem comes in when the inflation trend is stemmed and reversed.

As businesses and individuals continue to borrow and inflation continues to rise, the Federal Reserve (which will be discussed in further detail later) tends to step in to correct the problem. As these controls are activated, the inflationary trend changes direction. As history shows, there will always be a group of individuals and businesses that do not realize the trend has ended. As interest rates climb, they are caught with an excessive debt load which they can no longer service. By 1986 the excessive debt load was being noticed and by the early 1990s a record number of business and individual bankruptcies were declared and resulted in a high unemployment rate (1990-91). There has been a slow economic recovery since this recession and the inflation rate (consumer price index) has been trending downwards since then.

Part of the formula of a strong bull market is when inflation is perceived as being in control. During some of the best bull markets all you needed was a dart board. While the dart board is NOT recommended, these bull markets all had something in common - inflation was in control. This effect can be observed in the following super bull markets: 1920-29; 1949-66; and, in the current bull market.

Inflation also has a direct effect on interest rates. As the inflation rate climbed from the 1970s until the late 1980s, the demand for debt financing was high. Like anything, if the demand is high, so is the price, so interest rates were equally high. In 1990, the recession and the huge number of bankruptcies dramatically reduced the general debt demand. By 1993, interest rates fell about 4%. This drop in interest rates also made CDs and money markets less attractive to investors and led to a significant shift in assets to stocks and bonds (which was the beginning of the new bull market).

see hyperinflation