Deflation and Inflation trends can hurt investors when they move to extremes.
In a deflationary environment, businesses and consumers feel less wealthy, which will result in less consumption and spending. Lower consumption and spending can lead to a further drop in future demand. As prices decline further, companies generate lower revenues and profits. When consumers expect prices to fall, they may delay their purchases. Lack of demand causes businesses to cut prices, leading to a downward spiral in prices. A prolonged period of deflation ultimately leads to job losses, corporate and personal bankruptcies, and even home foreclosures.
Rising inflation in the US is not as destructive as deflation. But it does impact the consumer and the investor. Inflation can lower your standard of living, especially if your income does not keep pace with rising costs. Inflation can also erode the value of your financial assets.
The major difference between deflation and inflation is that under modest inflation you will not lose your job or companies will go under.
Fundamental Measures of Inflation and Deflation
The most common measure of inflation is the Consumer Price Index (CPI). CPI consists of a basket of goods such as consumer goods and services, health care, and transportation expenses. Economists and investment professionals typically follow this basket closely to understand the purchasing power of the US dollar. Investors will also monitor interest rates, wages, unemployment, and commodity prices such as CRB Index, WTI Crude Oil, Copper prices, Gold, and industrial metals to gauge economic conditions.
Technical Measures of Inflation and Deflation
Interest rates and commodity prices can often predict the sustainability of inflation and deflation forces. The simplest way to determine if inflation or deflation is developing is to follow the performances of a basket of inflation-sensitive and deflation-sensitive stocks. Running a ratio analysis of the two baskets of stocks can identify the inflection points when the economy shifts from one cycle to the next as stocks are a leading indicator of US business cycles. Signs of persistent inflation or deflation pressures tend to occur well in advance of pivotal economic turns.
Inflation and Deflation Index
Martin Pring, a famous Technician, developed the Pring Inflation index, a basket of mostly mining and energy stocks. The index tends to excel when the economy is strong and growing. The Pring Deflation index is a basket of deflation-sensitive stocks - namely financial companies, banks, insurance companies, and utilities. The index tends to excel when the economy is weak or during the early phases of an economic recovery.
Pring Inflation Index/Deflation Index is simply a ratio of the Pring Inflation Index divided by the Deflation Index. A rising ratio implies rising inflation, and a declining one warns of a deflationary environment. Historically, the ratio has been dependable in forecasting peaks and troughs in commodity prices.
A brief analysis of the inflation/deflation weekly ratio (0.24) shows a potential bottom has developed during 2019 and 2020, evidenced by a higher-low pattern. A pivotal low developed during Jan 2016 at 0.157, followed by a higher low during 2019/2020 at 0.169. A 5-plus year downtrend from 2016 hints of a symmetrical triangle pattern as defined by 0.157-0.169 (bottom of triangle) and 0.290-0.309 (top of triangle).
The ability of the ratio to clear above 0.290-0.309 confirms a breakout and signals the start of rising inflation. Some form of inflation may be good for the economy if it is trending modestly higher for the right reason since it hints at a sustainable economic recovery or an expanding economy. A persistent and longer-term rise in the inflation rate warns of an overheating economy. Since 2009/2011, the dominant trend of the ratio is a primary downtrend. A breakout above the 38.2% retracement from 2011-2016 at 0.60 is needed to confirm rising inflation. A current reading of 0.24 suggests nominal inflation, at least from a long-term perspective.
Violation of the bottom of the triangle (0.157-0.169) confirms a technical breakdown and warns at the start of the next deflationary trend. A deflationary trend that spirals out of control is far more difficult for the Federal Reserve to control than a modestly rising inflationary trend.
The symmetrical triangle pattern in the ratio suggests that a breakout or breakdown will likely confirm the next directional trend in the Inflation/Deflation debate. It is the Bollinger Bandwidth that currently shows an extreme contraction (pinching) that warns of an impending move. The Bollinger BandWidth is currently trading at 9.58. The last time this occurred was during March 2021, when the Bollinger Band Width fell below 10. The red vertical dash lines show prior occurrences when the Bollinger Band Width was below 10. A decline in the Bollinger Bandwidth below 10 does not offer guidance as to the direction of the next move. Instead, it hints that an impending move will soon develop. The %B indicator is another overbought/oversold indicator that also points to an extreme and unsustainable condition over the near term. The sideways trading trend is likely coming to an end. Expect a dramatic move will soon occur.
Despite widespread concerns about rising inflation, the inflation/deflation ratio has yet to confirm real inflation.
Based on the above analysis, inflation can develop in the future. However, the ratio has yet to confirm the current rising inflationary trend can lead to an extreme type of inflation condition such as hyperinflation. A triangle breakout above the top of its 5-plus year symmetrical triangle would confirm real inflation. In the meantime, modest inflation may be good for the economy as this will allow for the continuation of the stock market bull trend, at least from a longer-term basis. Volatility will remain high over the near term, as investors digest the inflation data and scrutinize Fed’s monetary policies. An economy that is not too hot or too cold is a goldilocks environment, an ideal situation for stocks. In this scenario the economy has steady economic growth, preventing a recession, but not too much growth that inflation rises by too much.