Inflation’s Been Brutal On Stocks, But Its Reign Of Terror Might Finally Be Over

Inflation’s Been Brutal On Stocks, But Its Reign Of Terror Might Finally Be Over
Carl Hazeley

almost 2 years ago4 mins

  • Technical analysis of historical patterns of inflation suggests we’re past the peak, but investors haven’t noticed yet.

  • Further technical analysis of the proportion of stocks that rise versus fall each day suggests that markets are due a rally soon that might be bolstered by fading inflation.

  • Buying stocks via ETFs is one direct way to benefit if the analysis turns out to be right, or you can use options to bet on where stocks go next with less cash upfront.

Technical analysis of historical patterns of inflation suggests we’re past the peak, but investors haven’t noticed yet.

Further technical analysis of the proportion of stocks that rise versus fall each day suggests that markets are due a rally soon that might be bolstered by fading inflation.

Buying stocks via ETFs is one direct way to benefit if the analysis turns out to be right, or you can use options to bet on where stocks go next with less cash upfront.

Record-high inflation – and central bank rate interest rate increases aimed at containing it – have been dogging the market all month. But according to noted technical analyst Larry Williams, those inflation pressures are about to go away, setting the stage for stocks to rebound between now and the end of June…

What is Williams’ argument?

To interpret Williams’ chart-based analysis, it helps to understand two measures of inflation. The flexible consumer price index (CPI) tracks the cost of items whose prices change quickly – think food, energy products, cars, or hospitality. The sticky CPI, meanwhile, tracks the cost of items whose prices change slowly – education and medical services, for example.

Right now, flexible CPI is high. In fact, it’s considerably higher than it’s been at any of its peaks in the past 50 years.

Sticky vs flexible CPI
Source: CNBC.

But if you strip out food and energy, which are the most volatile items tracked in the flexible CPI, you get a different view. And historically, this core flexible CPI has been a reliable indicator for where the sticky CPI goes next.

That’s the first bit of good news: the rate of change for the core measure peaked last year, suggesting that sticky inflation should begin falling soon. In other words, it’s possible we’ve turned the corner from high inflation, just that investors haven’t noticed yet.

Rate of change of inflation
Source: CNBC.

What does that mean for stocks?

To answer that, you first need to look at another tool in Williams’ analysis: the advance/decline line (in black), which tracks the number of stocks that are increasing versus the number that are falling each day. It’s a useful way to understand the strength or weakness in a stock market rally or decline – i.e. whether a few big stocks are driving an entire index, or whether the majority of stocks are moving in the same direction. It’s also useful to try to predict where stocks might go next (in red).

Advance decline line
Source: CNBC.

And here’s the second bit of good news. That forecast suggests it’s time for the advance/decline line to go higher, which would mean a stock market rally that could last through the summer.

Of course, Williams’ forecast also suggests we’ll get a pullback going into August, followed by an end-of-summer bounce. As for how high that bounce will go, the jury’s out: one drawback of the methodology is that it doesn’t tell you the size of a potential move…

What’s the opportunity here?

If we’re beyond the height of inflation like Williams’ analysis suggests, central banks might not end up increasing interest rates as much or as quickly as everyone expects – which could be good for the market. Couple that with the technical analysis that suggests stocks are due a rally, and now could be an attractive time to buy stocks.

There are two ways you might want to play this. The first is by buying stocks directly – perhaps via an ETF – to benefit from the potential rally. Given that time in the market is often better than timing the market, you might want to brace yourself for a rocky August, instead of trying to time precisely when to sell and buy back in. The Vanguard Total World Stock ETF (ticker: VT, expense ratio 0.07%) tracks stocks all over the world, and the Vanguard Total Stock Market ETF (ticker: VTI, expense ratio: 0.03%) tracks US stocks specifically.

The second is by using options: if you want to bet on rallying stocks with a smaller upfront fee, look at buying call options on stock market ETFs with a “strike price” above current levels (which give you the right to buy at that higher price, even if prices rise further). Put options – which give you the right to sell stocks at a certain price – could help protect you in case of an August selloff. And combining calls and puts with the same strike price – a strategy known as a “straddle” – could set you up to profit from stock market volatility in either direction. And of course, you can set up multiple straddles at different price levels and adjust depending on how those potential rallies develop.

But a note of caution if you go ahead: while some people will argue that technical analysis provides valuable short-term trading signals, its critics will say it’s pseudo analysis. And countless studies haven’t convincingly shifted the needle one way or the other. Still, whether you believe in the signals or not, they’re worth keeping an eye on, because some traders will be using them to make decisions. And when enough of them do, technical analysis prophecies can become self-fulfilling.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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