Why Is the Market So Bullish?

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In the past three months, the S&P 500 has marched up more than 8% -- a substantial, bullish stride. Why?

Is it because the National Bureau of Economic Research announced that the recession ended all the way back in June 2009? Hah. Nooo.

Is it because mounting expectations for Republican gains in Congress ultimately gave way to a historic landslide victory for pro-business ideology on Election Day? Possible, but doubtful.

Is it because quarterly corporate earnings numbers were so strong, and investors expect more of the same in the future? Perhaps partially, but not totally.

So, what is really fueling this impressive bullish movement?

It rhymes with sensation
My guess is that inflation is rearing its head. The government denies this (read Wednesday's FOMC notes to confirm). But, I believe recent gains in the stock market are simply another indication of inflation's legitimate presence.

In times of inflation, it's reasonable to expect stocks to be affected in ways that are similar to the effects of inflation on your wallet. Prices of everything tend to go up.

We're already seeing commodity prices ticking upward rapidly. We're seeing companies like McDonald's (NYSE: MCD  ) , Kraft (NYSE: KFT  ) , AmBev (NYSE: BUD  ) , Molson Coors (NYSE: TAP  ) and United Technologies (NYSE: UTX  ) plotting price increases in terrible consumer environments. We're witnessing significant pressure on the U.S. dollar compared with other world currencies. These are all telltale signs of inflation. And, of course, we're seeing stock prices go up at the same time.

Does that definitely mean inflation is the sole cause of the market's strong performance? No. But, it does seem increasingly probable.

The hand that rocks the cradle
With yesterday's announcement that the Fed will initiate Operation: Bleed Americans Dry (also known as QE2), we have another defined catalyst on our hands. The government will now add an additional $75 billion per month to the banking system, which, according to many economists, is an action that will directly cause inflation.

It's therefore becoming clear that the stock market's recent strong performance has a whole lot more to do with specific monetary forces than it does the actual success of America's top businesses.

Rarely does one thing ever explain the movement of an entire stock market. But, in this case, it's hard to ignore the possibility.

Examine the evidence. In blue you'll find the value of the euro versus the dollar, and in red, you'll find the performance of the S&P 500. All periods are over the past 3 months. Take a look:

Oddly enough, the performance of these two separate entities is close to parity -- both up about 8%. Of course, the euro doesn't exist in a vacuum. It has its own unique forces pushing it.

So, let's take a look at another major currency and see what's happening: the Japanese yen. In blue, you'll find the yen versus the dollar, and in red, the S&P 500:

Again, two wholly separate entities have performed remarkably similarly over the past three months. Weird, yes?

Let's check a non-major currency for an even better look. Here's the performance of the Indian rupee in blue over the past 3 months relative to the S&P 500 in red:

Not quite as perfect, but the two are certainly moving in tandem and in similar magnitude to the others.

Finally, perhaps the most telling chart of all: Here's the performance of the SPDR Gold Trust (NYSE: GLD  ) in blue compared with the S&P 500 in red. Not exactly a true currency, gold has taken on some of the characteristics of one. Take a look:

The two are moving in stride, with gold's appreciation being considerably greater (I suspect that's driven primarily out of speculation in the metal).

What does it all mean?
Of course, this is could all be totally random movement, but I don't think it is. I think stocks are going up (often in the exact same degrees as comparable entities) not because good things are happening here, but because the U.S. dollar is becoming worth less. The stock market is simply making corresponding efforts to keep up. This is an obvious statement, but an important one nonetheless. Consider just a few implications:

First, the government is still denying that inflation is even here. I think I've presented yet another strong indication that it is. Why are they doing this?

Second, it might feel good to be a stock owner right now as prices go up, but we're all simply ducks in a rising lake. I'll take it, but it's not like we're doing anything special as investors -- we're merely staying afloat.

Third, if you're not in stocks (or certain commodities), you're probably hurting. If this trend continues, fixed income owners and cash holders are probably going to get brutalized. I think it's prudent to invest in stuff that floats.

The Foolish bottom line
I believe that inflation is here. I'm not surprised, either. It's the natural by-product of our government's stimulus program. The good news is that there's plenty you can do about it.

Holding high-quality stocks is your best option. As the dollar declines in value, top companies will be able to push through price increases, increase their own cash flows, and correspondingly increase the value of their stocks. There are certainly other strategies to take if you wish. The larger point is that you'll be OK as long as you take corrective action against what seems to be a mounting trend.

Fool Nick Kapur is heavily invested in the world's top businesses, but none of the ones mentioned above. The Fool owns shares of Molson-Coors. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 08, 2010, at 3:37 PM, henryking54 wrote:

    Non-scholar and newsletter shill Nick Kapur:

    "I believe recent gains in the stock market are simply another indication of inflation's legitimate presence."

    Scholars Prem C. Jain and Joshua G. Rosett:

    "the use of inflation expectations as an input to investment decisions may be misguided."

  • Report this Comment On November 09, 2010, at 12:24 AM, mikecart1 wrote:

    RIP United States of America 1492-2011


  • Report this Comment On November 09, 2010, at 12:32 AM, goalie37 wrote:

    I'm not a believer that the market is always right, but the message of the last few days is clear. If you have an asset that isn't green and doesn't have a picture of George Washington on it, it is preferreable to an asset that does.

  • Report this Comment On November 09, 2010, at 1:34 AM, cpapsu7 wrote:

    "RIP United States of America 1492-2011"

    Really dude...does July 4th 1776 ring a bell, maybe? You really don't need to be worried about monetary policy if you think this country was founded in 1492.

  • Report this Comment On November 10, 2010, at 4:42 PM, GettinTheFlow wrote:

    I am neither an economist nor the son of an economist, but I do own some stocks, all of which are going up right now. I wasn't quite buying the "Oh, now we're recovered" line, which is spoken in harmony with "It's the previous administration's fault" line.

    Nick's explanation is disturbingly compelling and one of the reasons I love this site. (Have I mentioned my stocks are going up?)

    Many thanks to MF for the great info!)

  • Report this Comment On November 10, 2010, at 4:42 PM, GettinTheFlow wrote:

    Sorry. Meant TMF!!

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