For what it's worth, I continue to have a more optimistic view on the economy than the consensus and if that translates to improving jobs numbers—especially if deflation risks subside and inflation concerns kick back in, that could mean we face the prospect of the Fed easing off the gas pedal sooner than is presently anticipated. We remain in the camp that believes an environment that justifies a zero interest rate policy in perpetuity is not good!
Which "flation" is it?
What is unique today, and stoking the debate, is the bifurcation globally in terms of inflation/deflation.
Rapid economic growth has driven up price and asset inflation in China, India, Brazil and other emerging economies. These are regions with relatively low incomes and high and rising rates of inflation.
Then there's the other side of the story—places like the United States, Western Europe, Japan and Australia, which have slower economic growth, higher incomes and lower inflation rates.
Inflation/deflation and markets
The threat of deflation here in the United States has had important implications for stock market action and I'll highlight a few of my most tried-and-true charts supporting the relationship between inflation/deflation and the market.
The second bar in the chart, "Stocks hate severe deflation, but love mild deflation," shows that the zone of "flation" the stock market most favors is actually mild deflation. But the zone that stocks detest is just to its left—the "severe" deflation zone.
As you can see by the numbers in parentheses above/below each bar, which show how many periods we were in each zone, most of history (since 1926) has been spent in the low inflation zones, where we sit presently. But, it's fear of the toxic form of deflation that characterized the Great Depression that has caused some hiccups for the market this year.
Stocks hate severe deflation, but love mild deflation
Click to enlarge
Source: The Leuthold Group, as of June 30, 2010. Dotted line shows average total return.
Inflation, or lack thereof, can also impact valuation. For the same reason a dollar of earnings you and I make is worth more to us when inflation is low, corporate earnings are worth more when inflation is low. But when inflation gets too low or disappears altogether, valuations also suffer as you can see in the table below that I've highlighted many times.
Valuations love low inflation
Although we are presently in one of the sweet spots for valuation, it's probably fear of deflation that has kept current P/Es generally quite low relative to history.
