The FRED Report ( www.thefredreport.com) prides itself on being strategists that use market analysis techniques to examine the economy. After all, for investors, how the market reacts to news is often more important than the news itself. We are often asked to weigh in on the inflation vs. deflation debate -- what are the market indices saying about this important question especially as the Federal Reserve Open Market Committee (FOMC) is set to come down from the mountain at 2:15 EDT. First, we give some quick definitions. Deflation is occurring when prices of commodities are falling, cash becomes more valuable, and debt is considered to be bad as you are paying it back with cash that is becoming more valuable. The depression in the late 1920s/early 1930s was characterized by deflation. Inflation is occurring when prices of commodities are rising. Cash becomes less valuable and debt can be a positive as it is being paid back in cheaper dollars. The following example will help to understand the difference between the two. Let's say we buy a $100,000 asset on credit. In a deflation environment, the price of that asset could fall to $80,000. If there is inflation the price could rise to $120,000. You can see how cash becomes more valuable and a physical asset less so, or vice versa. Now we turn to some weekly not daily charts to evaluate current conditions. First is a chart of the dollar and then gold. A look at the weekly chart of the dollar using the Powershares Deutsche Bank U.S. Dollar Index (UUP) suggests that the market thinks cash is less valuable than it was a year ago. A look at gold via the Streettracks Gold Shares (GLD) suggests the market prefers gold to the dollar. Our interpretation here is that the market is more concerned with inflation than deflation, at least at this juncture. Moreover, charts of the Silver Trust ETF (SLV) and the Market Vectors Steel ETF( SLX) and the Deutsche Bank Commodity Tracking Fund (DBC) have seen major price moves from the 2009 lows and these trends do not appear to be over. Next we show a chart of bonds over the same period. While it is true that rates have fallen lately, the 30-Year Treasury Bond (^TYX) is nowhere near where it was in 2009 validating that in fact interest rates on the long end have risen from the lows of 2009. This suggests that, in spite of the rhetoric, there is more concern in the markets over inflation than deflation.
Now let's discuss the stock market. It is widely accepted in market studies that the broad market peaked in 1927 and the Dow Industrials in 1929. After the crash of 1929, the Dow 30 rallied to around the breakdown point, and then turned down into 1932. The smaller cap issues did not budge. This is important because the Dow 30 have basically done the same thing -- that index is right where it was in 1930 at that post crash peak. However, when we examine the chart of the iShares Russell 2000 Index ETF (IWM) we note that, unlike 1929-1930 it has moved above that breakdown point, is showing long-term outperformance relative to the Dow 30. This outperformance is also occurring in the S&P Mid-Cap index. We discuss this in depth in our latest Monthly Review, but the conclusion is that smaller capitalization, broader indices are doing better than larger caps, unlike the 1929-1930 period. If companies were unable to pass along price increases or at least hold prices steady, then earnings would suffer and small and mid cap stocks would not be leading. Indeed the outperformance of these names, suggests that investors are in fact betting on the recovery of the U.S. (and not international) economy and with that comes inflation. We note that traditionally smaller capitalization names have a tendency to outperform as recessions end . As growth picks up then inflation begins to reappear. Since the 2009 lows, this has been occurring. We continue to see strength in sectors that suggest the economy is improving as well as sectors that benefit from inflation, although the pace of that recovery may be slowing (see last week's article on Materials and Industrials). The conclusion one must draw is that the economy remains in a period of slow growth but with a slight inflationary not deflationary bias.