S&P 500 price action is the very definition of inflation
Too much money chasing too few goods, anyone?
In the immortalized words of economist Milton Friedman, inflation is “always and everywhere a monetary phenomenon.” The educated consensus, until the post 2008 world really began challenging it, was that sustained inflation was tied to sustained monetary expansion. Yet the Federal Reserve of the United States has been engaged in sustained monetary expansion in earnest for over a decade, with no runaway inflation yet in sight; well, not of the systemic variety informed by the CPI, PPI, or GDP deflator, at any rate.
The world’s stock markets, on the other hand, have become visibly inflated since the Great Recession. For example, after bottoming in March of 2009, the DOW climbed to record nominal values over the next 11 years. It topped in February 2020, right before the full impact of the global pandemic was felt in the United States. Thereafter, it plummeted, of course, only to climb out of another hole given the Fed’s renewed and unprecedented support. This mimics the experience of so many other indices.
That said, the DOW has not set any new records (yet). The S&P 500, however, has.
To understand why that is, it is not enough to know that inflation is a monetary phenomenon, or that the Federal Reserve is expanding the money supply to an incomprehensible degree. It also does no good to question whether Wall Street is detached from reality, as so many fluff news pieces have pondered. (In case you were wondering, Wall Street isn’t detached from reality, by the way — it’s just a concurrent reality.) Rather, we must seek to assimilate four critical pieces of information:
Inflation can occur in limited areas of the economy or be of specific types (siloed inflation).
Inflation, in crude terms, is too much money chasing too few goods.
Expectations are everything.
Stocks are a consistent and well-established hedge against inflation.
Inflation doesn’t have to be realized in common household goods or pervade the whole economy in order to make an appearance somewhere. Take housing, for instance. It was one of the only areas to see headlining inflation since the ’08 crisis. While it took a bit for the ship to right itself, the housing market grew quite hot again (and the gains persist as of this story’s publication). New automobiles and stocks are other delimited areas in which we’ve seen inflation.
We know it is inflation because we saw outsized gains that have priced some people out of the markets, or at least out of particular locales and securities. A dollar buys disproportionately less in both those markets than it used to, and it has happened relatively quickly. One of the only reasons small retail investors have still been able to participate in securities trading is because of fintech innovation, including fractional share holdings and commission-free trades.
However, the other side to this is the astronomical rise of penny stock, bankrupt stock, and options trading. Why? Because for comparatively little money, you can get in on the action. Options, in particular, give the contract holder access to the price action of 100 shares of a quality underlying when they could otherwise never afford to purchase 100 actual shares of the underlying. Many stocks cost too much, while many options contracts don’t, and the latter offer a much more “interesting” experience.
Too much money chasing too few goods
With more investors entering the financial markets; the ever-expanding money supply; and the increased velocity of money in trading activities (especially given transaction enhancements like fee-free trades), the cash at play far outweighs the number of securities available for purchase, be they stocks, derivatives, bonds, ETFs, or mutual funds. In particular, while new funds are being created all the time, the universe of equities is limited. Sure, new companies arrive on the scene via IPOs and lately reverse mergers, but the introduction of new equities to trade cannot keep pace with demand.
In this way, particularly, the S&P 500 is the very definition of inflation. There are always only 500 companies. Should one fall from grace, another shall take its place. Indeed, just recently, six of corporate America’s household names traded places: online retailer Etsy, semiconductor equipment manufacturer Teradyne, and medical technology firm Catalent were welcomed to the club, replacing tax specialist H&R Block, beauty company Coty, and retailer Kohl’s.
In the midst of a global pandemic, the S&P 500 is also arguably the safest index on the planet, perpetually comprised of the highest-caliber companies America has to offer. This is the index that will supposedly make it to that dimmest of lights at the end of the tunnel.
The Fed is backstopping corporate debt and lending directly to certain companies, to boot, never mind the varied forms of stimulus it has unleashed. With excess money sloshing around in the system, it has to go somewhere, and an ever-increasing amount of it has gone into futures, funds, and options that derive their value from the S&P 500, as well as the shares of those companies themselves.
In other words, a growing quantity of “too much money” is chasing an amount of “too few goods” that is limited by design and perceived as one of the most secure places to park growing hoards of capital. What’s more, the potential returns on that index outstrip those available on US Treasuries. Yes, the S&P 500 is setting records while the federal government still has not reached agreement on further stimulus, millions are unemployed and facing tragic levels of hardship, and bankruptcies, personal as well as corporate, abound. All the while, the Fed is pledging to keep up their stimulus efforts for years to come.
Expectations are everything
What really gets nations and economic participants into trouble is when considerable unexpected inflation strikes. Technically, unexpected inflation is the difference between actual observed inflation and expected inflation. The Fed is being careful to let it be known that they won’t be caught off guard by the unexpected. Take Jerome Powell’s August 27, 2020 speech to close out the annual Jackson Hole symposium. Therein, he formalized the Fed’s new approach to inflation: average inflation targeting.¹
In short, the Fed will now target an average 2% inflation rate over time. Details are scarce, but inflation will be allowed to run hot at times and cool at others. This, instead of the Fed preemptively adjusting the dials to target an actual 2% at all times and avoid unexpected systemic inflation. The micromanaging, the tinkering, is done with for the foreseeable future. Reading between the lines, the Fed wants us to know that if we see any systemic inflation as we freight train our way through these catastrophic times, not to worry: It’s all under control, it’ll get sorted, and it’s anything but unexpected.
Presumably, this should leave us to go about the business of surviving the onslaught of SARS-CoV-2, the attendant financial fallout, and even participate in the economy again some day.
Equities as an inflation hedge
Many children have long been told a fairy tale that gold is the fairest inflation hedge of them all. Any finance textbook worth its salt will set the reader straight on this point, though. Two of the most dependable hedges against inflation are energy and stocks.
But, how can the S&P 500 exhibit inflation and serve as a hedge against inflation, all at the same time?
One would have to return to the conversation about siloed inflation versus systemic inflation. Typically, when we discuss inflation hedges, we mean assets that can preserve our purchasing power in the face of pervasive or systemic inflation. While we may witness that type of inflation here at some point, primarily because of broken supply chains and laborless or bankrupt providers of goods and services, we don’t observe that currently.
What we do have, thus far, is too much investment capital chasing too few quality stocks. In the event that systemic inflation does rear its ugly head, such that we see our power to purchase common goods and services diminish, it is likely to enhance returns from investments in indices like the S&P 500 even further.
It bears saying that the run-up that has taken place thus far may not continue. Upward trajectories in index valuations are dependent upon further stimulus, for one. Should the Fed have to change course for any reason; should no more government assistance for households be forthcoming; should an additional something grave and unexpected strike in these unexpected times; should investors collectively decide that tulip bulbs make more sense, there will be greater outflows than inflows with regards to the S&P 500. In that case, unless modern society is finally collapsing, one may consider it another buying opportunity.
¹ Powell, Jerome H. “New Economic Challenges and the Fed’s Monetary Policy Review.” At “Navigating the Decade Ahead: Implications for Monetary Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (via webcast, August 27, 2020).