Why the Smart Money Isn’t Blaming Inflation for Weak Stock Prices

Blaming inflation for lower stock prices? The smart money certainly isn’t. The Dow Jones Industrials ended last week sharply lower — down 2.1% in a week in which investors traditionally trade light as they prepare for the holiday season. The media was quick to blame the reported rise in the U.S. Consumer Price Index in November (the biggest reported jump in two years in the CPI) for the drop in stock prices. A rising CPI, a measure of inflation, often signals firming interest rates, as the U.S. Fed has a policy of keeping interest rates high when inflation rises.

The smart money knows better than to blame inflation for the market’s poor performance. And the action of gold bullion confirmed this last week, when its price fell on the inflation news. Here’s what is really happening:

Inflation as measured by the CPI is an antiquated measure. The CPI is built on a very old model — one where housing, which is likely the largest single monthly expense of a consumer, is given very little weight. I personally believe that seasoned economists and the smart money crowd stopped giving credence to the CPI figures years ago.

When I look around today, I see falling stock prices… I see falling house prices… and prices for retail goods at non-luxury brand stores declining (clothing, home furnishings and electronics prices are declining the fastest, thanks to cheap Chinese imports).

The media has it all wrong blaming inflation for cheaper stock prices. In my opinion, the single biggest threat to the U.S. economy and to the Fed in 2008 is deflation. You can bet the Fed will expand the money supply and drop interest rates aggressively as deflation starts to rear its ugly head.

How about the value of the U.S. dollar against other world currencies as the Fed brings down interest rates? Forget it. If the Fed needs to choose between domestic deflation/recession and a collapsing currency, my bet is that it will forego the concern over the plummeting value of the U.S. dollar. To all those investors holding non-U.S. based investments: The best gains from foreign currencies are yet to come.