Market historian eyes inflation hedges

March 9 will mark the fourth anniversary of the start of this bull market. In a maturing bull market, it�s important to be vigilant for signs of rising inflation and a tightening monetary policy.

Below, we look at the indicators to watch. also We also review the market's various sectors in terms of which historically do best and worst in inflationary periods.

Even if there is another leg upward, as currently indicated by technical and fundamental evidence, this bull is no longer young by historical standards. Odds are almost certain that we�re now in the latter half, if not the final third, of its lifespan.

In watching for potential inflationary pressures to emerge, there are several important tools that can serve as an early warning system. Used together, our primary gauges for assessing the inflationary outlook should provide the earliest signals that prices may be heading higher:

• The ISM �Prices Paid� Index signals when manufacturers are paying higher prices for their inputs or supplies. And increased costs are eventually passed along to customers. This Index is currently sitting about in the middle of the long-term range and well below the 70 threshold that would indicate high inflationary pressures.
  
  
• Future Inflation Gauge (USFIG), which is comprised of leading economic data, is designed to measure underlying inflationary pressures and predict turning points in the U.S. inflation cycle. This Index has slowly risen over the past 12-18 months to a 4-year high. Yet it is still below pre-recession levels and according to Economic Cycle Research Institute�s (ECRI) is not an issue at this time.
  
  
• Of greater concern is the recent trend in the CRB Spot Commodity Price Index, as this gauge measures changes in the pricing of industrial materials at the earliest stages of the supply chain. Commodity prices rebounded sharply coming out of the last recession, but they slumped in 2011-12 as economic growth slowed. Now they�re showing signs of renewed strength.

It�s too early to tell whether the recent upward trends in these gauges will build into broader inflation pressures, but these indexes certainly warrant careful monitoring. Also, while there�s little evidence of inflationary pressures right now, it�s not too early to think about how to add some protection in your portfolio.

To prepare for a potentially inflationary environment, we examined relevant historical market data for guidance.

Our analysis looked back at eight inflationary periods over the past 63 years since 1950, selecting periods when the 12-month rate of change in the CPI increased by more than two percentage points before subsiding.

It was particularly important to include the 1960s and �70s, which saw significant bouts of inflation. For instance, from 1976 to 1980 inflation as measured by the CPI soared from 5% to more than 14%.
Although stock information going back that far is limited, we were able to put together broad sector analysis utilizing data on over 40 separate industries.

Our research was focused on identifying which groups, if any, consistently rose to the top in terms of relative performance, and which fell to the bottom (i.e., were most negatively impacted by rising inflation). In ranking these industries, we found that a sector pattern emerged.

• Energy was by far the best hedge. The oil & gas industries, including integrated companies and equipment & services, averaged double-digit annualized gains during inflationary times, compared to a modest 4.2% average annualized gain in the S&P 500 Index. Overall, these energy groups beat the broader Index in at least 75% of the inflationary periods analyzed.
  
  
• Materials also typically outperformed the broader Index, but there were some weak spots among industries. Gold, metals, mining and paper products companies offered good protection, but chemical and container manufacturers lagged, presumably due to the rising cost of raw materials.
  
  
• Surprisingly, a number of Industrial groups also proved resilient, pushing this sector to number three in the ranking. Industrial machinery, electrical equipment and aerospace manufacturers averaged close to 10% annualized growth, perhaps because they were able to push through higher costs. Airlines and trucking were generally among the weakest segments, likely due to rising oil and gas prices.

Despite some variation among industries, these sectors on the whole appeared to hold up well, or even benefit, during inflationary times.

Conversely, looking at the worst performing sectors, rising prices and corresponding increases in interest rates took a heavier toll.

• The Consumer Discretionary groups were the most susceptible to rising inflation as buyers cut back on higher priced items. This was particularly true in the automobile and home furnishings & appliance industries which averaged annualized losses greater than 6%.
  
  
• The Utilities and Telecom stocks also offered little protection as companies in these capital- intensive sectors are particularly vulnerable to rising borrowing costs.

What�s interesting about this ranking is that the sectors that have historically offered the best inflation protection are typically mid- to late-cycle sectors that also tend to lead in maturing bull markets. Thus, they should be lower risk holdings at this point in the 31/2 -year old economic recovery.

Portfolio Strategy

Currently in the Model Fund Portfolio, about 30% of our sector ETF allocation is in the top inflation hedge groups (Energy, Materials and Industrials) with half of our recent additions in these sectors.

Meanwhile, less than 10% of our ETF positions are held in Consumer Discretionary, Utilities and Telecom funds. Outside our ETF positions, 6% is invested in foreign funds not directly affected by U.S. inflation.

We�re comfortable with this allocation as long as inflationary pressures remain subdued. Looking ahead, however, we�ll be watching inflation gauges closely and will likely shift more out of the vulnerable Consumer Discretionary sector and into the better hedges if such action is warranted by an increase in inflationary pressures.

We recently increased our position in the Financial Select Sector SPDR (XLF) from 3% to 9% and added a 3% position in the Materials Select Sector SPDR (XLB). We also increased the Energy Select Sector SPDR (XLE) position from 8% to 11%.

There is not a single recession in the past 50 years that has begun while the U.S. Leading Economic Index is hitting new recovery highs, and the 4-week average of Initial Claims for Unemployment was hitting a new multi-year low. None... zero... nada.

That doesn�t mean it can�t happen (NEVER say �never� when it comes to economics), it simply means that leading evidence is not confirming an imminent recession.

The time-proven technical tools we use in gauging breadth (participation), bellwethers and leadership are some of the most reliable indicators near major market tops. We can�t say this evidence won�t shift in the months ahead, but for now that evidence is remarkably strong for a bull market of this age.

And in terms of valuation, while no one (with any historical perspective) can call this bull market �cheap,� today�s P/E ratio for the S&P 500 is still slightly below the 60-year average and significantly below the valuation peaks of the 2007 or 2000 market tops.

When compared to the average P/E when short-term interest rates are this low (less than 3%), one might even argue that stocks are 20% undervalued.



Related articles

• Street Smart: 'Big picture' is bullish
  
• The case for dividend stocks
  
• ContraFund: Best of breed bets