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.