Inflation and the Dow: How Stable Prices Can Send Markets Higher

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The Dow Jones Industrials (DJINDICES: ^DJI  ) were down 35 points as of 11:45 a.m. EST, reflecting some anxiety about potential market-moving news from the Federal Reserve later this week. Even as the economy has shown signs of strength, inflation has been completely absent. That has raised questions about the impact on the overall market, as well as on companies including oil giants ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) and tech stalwarts Intel (NASDAQ: INTC  ) and IBM (NYSE: IBM  ) .

Where has inflation gone?
November's figures from the Bureau of Labor Statistics showed continuing price stability, with the Consumer Price Index unchanged for the month. That puts the annual increase in the CPI at just 1.2%, well below the 2% figure that the Fed has targeted as an ideal level of annual price increases.

Energy prices once again fell sharply in November, with a 1% drop following October's 1.7% decline and accounting for just about all of the yearly drop of 2.4% for the CPI's energy component. Falling gasoline prices more than offset higher natural-gas prices, making consumers happy but leaving Exxon and Chevron looking at the potential for continuing declines in their overall revenue levels. Even with Chevron and Exxon working hard at boosting production, falling prices could cause problems for the energy giants. As a result, while both stocks trade at what appear to be attractive valuations, they could see their earnings multiples rise not because of soaring share prices but rather because lower earnings would boost P/E ratios.

For lessons on what falling prices can do to an industry, it's helpful to look at the technology sector. Technology has historically seen falling prices and the recent past has been no exception. Prices of PCs and peripheral equipment have fallen 8.4% in the past year, with software costs down 5.4%. Those factors have helped to put IBM and Intel among the rare group of Dow components that have seen falling overall revenue over the past year. Yet it's important to remember that these companies also benefited from falling prices during the 1980s and 1990s, as innovation continually made their products more affordable to a growing group of customers seeking the productivity gains that technology provided.

As concerned as many people are about deflation, most investors have forgotten just how bad inflation can be. The Fed is in the enviable position of being able to worry about small deviations from its targeted inflation level, and that in the end should boost markets as long as it can keep prices from moving too dramatically in either direction.

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