The specter of inflation hangs over stocks

In February, the Dow Jones Industrial Average fell 4.28%, the S&P 500 Index declined 3.89%, and the NASDAQ dropped 1.87%.

In my view, when looking at the historical performance of US financial markets, excessive inflation has often caused prolonged slumps in the equity markets.

In my opinion, the most obvious example is the 1973-1975 period, when the Dow Jones Industrial Average declined more than 50% from peak to trough.


February Slump

When strong indications of higher wages and goods suddenly appeared early in February, markets sold off hard.

Although not all of the sell-off can be attributed to inflation fears, for longer-term investors, the inflation numbers bear scrutiny in my view.

If one looks at the current combination of low interest rates, tax cuts, a robust economy and low unemployment levels, it seems obvious, in my opinion, that inflation may be perking up.

Robust Economy

Still, I think that due to deflationary forces like technology, overcapacity in real estate, abundant energy production and retail competition all providing an offset to inflationary pressure, markets have since rebounded from the sell-off in early February.

What else is happening in the economy?

Conditions for mergers and acquisitions, initial public offerings, corporate spin-offs and recapitalization are strong, and that bodes well for the financial sector in my view.

Consumer spending and confidence remain strong and companies are repatriating billions of dollars from abroad. That should support for the economy from the foreseeable future in my view.

Valuation Risk

I think the real risk for stocks remains elevated valuations. First- quarter earnings have been solid as the large banks and technology leaders post record profits and have rock solid balance sheets.

In sum, I conclude that inflation seems the key area investors should watch.

Photo Credit: dee & tula monstah via Flickr Creative Commons