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Our Real Earnings Yield (REY) Model shows that investors/traders tend to demand a reasonably consistent spread between the aggregate stock operating earnings yield and the (consumer) inflation rate. Our Trading Calendar shows the average behavior of the aggregate stock market (S&P 500 index) by trading day throughout the calendar year. Is there some way to tie the model and the trading calendar together?
The following chart compares the behavior of the average year-to-date change in the S&P 500 index during 1/90-9/05 with the average annual inflation rate by calendar month over the same period. Visual inspection suggests an inverse relationship. The stock market trends up (down) when the annual inflation rate trends down (up). The seasonal inflation rate peak in September aligns with seasonal weakness in the stock market that month. The seasonal inflation rate dip in the fourth quarter aligns with stock market strength during that period. The Pearson correlation between these two series is a moderately strong -69%.
This chart suggests that: (1) there may be seasonal trends in the inflation rate; and (2) investors/traders may react to these seasonal trends as the real value of stock operating earnings varies.
The actual annual inflation rate for a given month is not known with certainty until the middle of the subsequent month when the Bureau of Labor Statistics (BLS) releases new Consumer Price Index (CPI) data. Also, one month does not a trend make. In the REY Model, we assume that investors/traders use a rolling two-month average of the annual inflation rate for the preceding month and their best estimate of the rate for the current month. This approach smooths the effects of unusual months, as shown in the next chart in which the September spike and the fourth quarter dip are not quite so extreme as they are above. The Pearson correlation between these two series is a strong -77%.
Shifting the inflation rate plots to the right, such that investors/traders have assured knowledge of the inflation rate based on BLS CPI releases, reduces the magnitude of the correlation between inflation rate and stock prices. Perhaps investor/traders have significant clues about the real-time inflation rate. If we discover any reliable such clues, we will incorporate them into the REY Model. See Inflation Forecast regarding the fundamental and technical prediction of the inflation rate.
Note that the sample for the above analysis is only 15-16. Outliers (such as the inflation rate for September 2005) can have significant effects in such a small sample. As for all the Trading Calendar analyses, these results are therefore only mildly suggestive.
In summary, there may be some relationship between inflation seasonality and stock market seasonality.
A seasonal Fed Model analysis should produce similar conclusions to the extent that 10-year Treasury note yield (or whatever interest rate one may use as a benchmark for stock earnings yield) parallels the inflation rate.
For related research, see Blog Synthesis: Calendar Effects and the Trading Calendar.
