By Michael Brush
When central banks, most notably the Federal Reserve these days, move too aggressively on interest-rate increases, things break.
Believe it or not, this is bullish in the twisted thinking of Wall Street. It’s why stocks rallied earlier this week.
Before you laugh this off, consider the logic. It is not completely absurd.
Faced with a financial crisis that threatens systemic risk — because a bank or investment firm “breaks” — the Fed might well abandon the policy-tightening plan it has mapped out. This would remove the heightened risk of recession. And that would be good for stocks.
“Markets stop panicking when central banks start panicking,” says Michael Hartnett, Bank of America’s chief investment strategist.
But the best pushback on this thinking has investors selling. They think the Fed might not actually have the liberty to back off. Half of the Fed’s job is to control inflation — and headline inflation numbers tell us inflation is still raging.
“U.S. and euro-area inflation data do not allow for dovish central bank responses,” says Barclays strategist Ben McLannahan.
We can tell this bleak view is consensus because sentiment is so dark. However, this still may be wrong, which would mean you will make money if you buy stocks now.
This consensus view is wrong, to me, because behind the scenes — in what I call upstream inflation numbers — we see a lot of evidence that prices are falling fast and hard. As that bleeds through to the headline Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) index that get all the attention, investors will ease up on Fed-induced recession fears. Stocks will rally.
That extreme negative sentiment caused by recession worries is also a buy signal. More on that below. But, first, here’s what history tells us about inflation spikes, and why it will be coming down faster than people think.
‘ Round trips’ in inflation spikes are symmetrical
Historically, the amount of time it takes for inflation to spike is equal to the amount of time it takes for the spikes to reverse. Inflation probably peaked in March or April of this year, and it started to heat up in April 2021. This tells us the spike took a year to form, which suggests inflation will be back to levels that are not worrisome by next spring or early summer, says Jim Paulsen, an investment strategist at Leuthold, a market research group.
Sharp inflation spikes are excellent buy signals. In six of the seven biggest inflation spikes since the 1940s, once the CPI peaked, the low was in for the stock market.
“If you buy at the peak, you do pretty darn well over the next 12 months,” says Paulsen. Waiting until inflation is under control is not the way to go.
Take the three big inflation peaks during 1970, 1975 and 1980, an era that investors liken to the present. One year after the last two, the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.40% was up over 30%. A year after the first one, it was up 8.8%. On average, stocks are up 13% one year after inflation peaks when there’s a recession, and 17% in a no-recession scenario.
Here’s are seven major trends that are about to drive that symmetrical decline in inflation.
1. Energy prices are down sharply. West Texas Intermediate crude prices /zigman2/quotes/211629951/delayed CL.1 -1.07% are down 30% from June. A gallon of gasoline has fallen 23% since peaking in the same month. Energy is central to the economy, so its price has a big impact on the prices of almost everything. Plus, there is a psychological angle.
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