Inflation: Good vs. Bad

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It's funny how perceptions change. For most of my adult lifetime, the big idea was that stocks are your go-to shield against inflation. The logic? Stocks are tied to real stuff, so if prices go up, stock prices should too. I keep telling anyone who’ll listen: there is not a magic formula here. Stocks and inflation? It’s not a straight line—it all teeters on what’s fueling that inflation in the first place.

Check out this chart below: it's the rolling 5-year correlation between the S&P 500 and U.S. inflation. If stocks were a slam-dunk inflation hedge, you'd see a nice, steady positive line, maybe even close to 1.0. Nopee - for most of the last 70 years, it's been negative. Like, really negative. Stocks aren't really the inflation buddy we thought.

Rolling 5-year correlation between the S&P 500 and inflation 

The Recent Exception

Here's the weird part: most of my adult lifetime, that correlation's been mostly positive. For 15-ish years, stocks actually acted like a decent inflation hedge. So, what's the deal? Some smart folks at the Board of Governors of the Federal Reserve System wrote a fantastic paper. It's all about whether the market thinks inflation is "good" or "bad." The research helps explain why stocks sometimes rise with inflation and sometimes fall.

But when's inflation good or bad? Comes down to where it's coming from:

• Demand-driven inflation: People spending tons and the economy's buzzing—that's good news for stocks. Companies make more money, even if the Fed hikes rates to chill things out.

• Supply-driven inflation: Think oil prices spiking or not enough workers—that's bad. Higher costs hit companies, profits shrink, and Fed rate hikes just make it worse.

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Historical Context

Take a peek at that chart again. Back in the '70s, oil shocks drove supply-side inflation and crushed stocks. Then we had the massive COVID-19 pandemic supply chain disruptions in 2020-2021, which contributed significantly to the inflation surge we saw in 2021-2022. Same deal as the '70s - supply-side problems led to inflation that hurt stocks.

But from 2008 to 2019? That was different. No major supply messes during that period. Inflation came primarily from demand, a gradually recovering economy, so stocks looked solid. No wonder people bought the “inflation hedge” story—they hadn’t lived through the nasty supply-side stuff until the pandemic hit.

Right now, it's a bit of a mess. The San Francisco Fed's data shows U.S. inflation split between supply and demand—like, almost 50/50. (I skipped some fuzzy third factor to keep it simple.) It's a coin toss which way stocks go next.

Contribution of demand and supply effects to inflation

So yeah, stocks and inflation—> it's never been a straight line.

Depends on what's pushing prices up. I'm watching what's behind any inflation spike. The market's memory is short. Many traders and investors today built their inflation playbooks during a period that was historically favorable for equities. The question now: are they prepared for a different inflation regime? Those who understand this distinction will be better positioned for whatever comes next.

- John

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