Inflation and its Historical Impact on the Dow Jones

• A rare example of strong bipartisan action during the Trump administration, the monetary and fiscal support provided during the COVID-19 crisis was arguably necessary.
• However, the execution may have been flawed, resulting in severe consequences that society must bear today.
• While it’s not a time to adopt an overly pessimistic attitude, investors must prepare for the possibility of long-term consolidation or even downside.

When government and publicly elected officials realized that the COVID-19 pandemic would no longer be the exclusive domain of the foreign and the exotic, they faced a pressing dilemma. From a broader health perspective, they needed Americans to stay indoors and away from each other as much as possible. At the same time, economic and financial realities posed an impossible-to-overcome challenge -- that is without significant support.

Therefore, in a rare moment of bipartisan action, the monetary and fiscal powers of the U.S. -- under the contentious Trump administration -- combined to distribute unprecedented financial aid to hurting households. The impact was seemingly obvious. After succumbing to worrying lows, the benchmark equity indices such as the Dow Jones and S&P 500 bounced higher, eventually racing to all-time highs. It all seemed too good to be true, until perhaps it was.

One of the fundamental and unignorable truths about the blistering enthusiasm in the face of so much turmoil is that central banks can’t print their way to prosperity. If every crisis simply resolved itself through the loosening of the monetary spigot, then naturally everyone would do it. Alas, such actions have consequences -- severe ones, as the soaring inflation rate can confirm.

But what does this dynamic imply for the future? For that, it might help to look to the past.

The Dow and the Inflation Rate

If you were to compare the inflation rate to the Dow Jones index going back to the start of the 20th century (using historical data courtesy of MeasuringWorth.com), you’d be hard pressed to find a clear statistical relationship. However, if you conducted comparative analytics during certain periods of modern American history, some recognizable patterns start to emerge.

For instance, between 1950 through 1979, the Dow Jones and the inflation rate shared a 39% direct correlation. Statistically, such a coefficient would be considered on the fringe of usefulness. Nevertheless, you can see a general pattern that higher inflation benefitted the valuation of the Dow.

However, between 1980 through 2021, the Dow and inflation shared a 40% inverse correlation; that is, as inflation declined from its highs, the Dow responded positively, generally swinging higher. Of course, monetary policy is but one component of equity valuations. Still, the statistical relationship is almost the exact opposite of what occurred between 1950 and 1979.

What accounts for this sharp pivot? Namely, demographics. Following World War II, the U.S. entered a population boom and as this generation -- the baby boomers -- entered adulthood, the massive expansion of the population required a robust expansion of the money stock.

However, subsequent generations have saw declines in growth, meaning that the U.S. population pyramid -- as is the case with other developed nations -- is somewhat upside down, featuring more older people and fewer young people.

In this situation, central banks cannot justify excessive expansion of the money stock. But that’s exactly what occurred during the COVID-19 response.

Prepare for the Consolidation (or the Correction)

Although history is not guaranteed to repeat itself (or even to rhyme), it typically provides a useful insight as to what societies can expect in the future. Regarding inflation and the Dow, the forecast isn’t exactly pleasant.

Between 1945 and 1965, the U.S. enjoyed strong growth, fueled by post-war prosperity and optimistic sentiment. However, from 1965 to the early 1980s, that growth transitioned into nearly two decades of consolidation in the Dow. One of the main culprits was inflation.

Prior to this consolidation phase, inflation gradually rose, which wasn’t a problem because rapid population growth justified it. However, the inflation rate went bonkers throughout much of the 1970s, stifling the nation’s growth potential. It wasn’t until the Federal Reserve implemented severely hawkish policies that rising prices finally cooled.

Fast forward to 2000 and we see a similar economic backdrop. This time, it wasn’t the end of wartime that fueled growth but rather the advent of the internet. As digitalization radically imparted a paradigm shift on society, the Dow soared to record heights. During this growth period, inflation generally declined.

But in 2021, after roughly two decades of growth, inflation has once again reared its ugly head. Could we then face another extended period of either consolidation or decline? It’s very possible.

True, the inflation rate of today isn’t as bad as it was during the 1970s. Here’s the thing, though: it doesn’t need to be. Because we don’t have the population growth of the post-World War II boom, a lower (but still rising) inflation rate can create the same net negative impact as what we saw in the 1970s -- or even worse.

Not Fear But Preparedness

Unfortunately, the internet is rife with fearmongers attempting to paint an overly pessimistic view of the world and then in the same breadth presenting a magical solution to said problem. Being too negative about the present circumstances probably won’t help much.

At the same time, you don’t want to be in the other extreme and assume the best-case scenario. From the fundamental and historical data that’s available, there’s at least some probability that the wild post-COVID bull market will encounter a consolidation or corrective phase. Ultimately, then, the point is to stay cognizant of the risk factors and approach the capital markets accordingly.