Markets, Inflation and the Taylor Effect

by David Greig. April 13, 2006

I recently finished reading a fictional thriller by Robert Taylor, titled "Paradigm." The story’s protagonists stumble upon an ancient device that holds the secrets to entire generations of fortunes. Going back to the Egyptian era, the antiquity was used to divine certain consequences of gravitational effects. Without divulging the story’s secret, I can briefly say that the mysterious instrument was able to mechanically predict the entire course of today's modern stock market with uncanny precision. Now, before you dismiss this as pure fiction, I should mention that the inside jacket states that the author based the story on his own scientific research, which was nominated for a noble prize, adequately titled the "Taylor Effect." The author was generous enough to include a table that shows how the prior performance of the stock market exactly matches his predictions, and more importantly, he includes predictions for the future. The current year, 2006, is predicted to be a major down year. The prediction would seem baffling, considering the market's technical uptrend and strong January performance (recall the adage, "as goes January, so goes the year"). However, who am I to argue with an infallible relic that has accurately predicted the market's schizophrenic undulations since even before I was in diapers.

There have been no shortage of well thought out arguments from both bulls and bears in their defense; I'm a particular fan of the plunge protection team argument on the bull side. While I could compile an encyclopedia of arguments about why the market should go down, I've learned not to step in front of the freight train known as divine intervention (or the fed, if you're an atheist). Although, I have to admit, I have been surprised to see the paucity of late day saves, even in the face of rising gas prices and escalating interest rates. Is it possible that helicopter Ben, will not dip in to the now invisible M3 cookie jar? I'm doubtful of that. Therefore, while I'm cautious of climbing the wall of worry, I'm more cautious of shorting against the invisible deus ex machina that has a pesky habit of dropping in just about the time the market is about to fall off the precipice and into the abyss.

Figure 1. 10 Yr. Daily Chart of the NASDAQ courtesy of www.prophet.net

The Chart, in figure 1, shows the 10 yr performance of the NASDAQ. From my perspective, the long-term uptrend since late 2002 is still intact, and until this channel breaks on pretty heavy volume, I would be pretty cautious about shorting. One possible trajectory is shown in blue; this matches the earlier comparison with the DOW I outlined in an earlier article titled "The Cycles haven't changed much." From a purely technical perspective, and considering the unusually strong showing of the first five days of January, I would slant my bias towards the upside. If it does pull back, I would consider 2100 to be a very strong support line. One potential fly in the ointment however, could be inflation.

Figure 2. Source: BLS, Yahoo Finance, and KITCO

The graph in fig. 2 shows that gold outperformed stocks, during the seventies and into the eighties, when inflation was soaring. The steady rise in the S&P took off as inflation dropped precipitously in the early eighties. During the early nineties, the S&P overtook Gold's mighty lead and has remained the leader for almost two decades. The spike in inflation in 2000 (partially prompted by several interest rate hikes to quell the market), triggered a change in the relationship between gold and stocks, whereby gold and commodities in general began to take off. There seemed to be an almost perfectly inverse relationship between the nearly sinusoidal waves of gold and stocks up to 2003; that changed as the FED went all out to fight a potential market disaster by dropping rates several times in succession. It's interesting to note that the relentless rise in gold has not abated, despite the enormous conspicuous activity to keep it subdued by large commercial traders. One possible scenario could be that the S&P will drop back down to cross under the gold wave, while gold continues its climb. However, I suspect that if inflation stays contained within the 2-5% range it has managed to maintain over the last two decades, it would have a minimal effect on equities, while keeping gold on a leash. The big if, however, is what happens if inflation really begins to take off. During the 90's recession, we saw inflation pop up for awhile. Oddly enough, that didn't affect the rise of stocks, nor did it nudge gold up much. Therefore, I further suspect it would take an enormous surge in inflation (or at least a very sharp and rapid rise as it did in 2000), to kick the markets back down. While this is possible, I think the fed will go out of their way to accommodate the market and temper rate increases. That being said, the converse is also true. I could see how gas shortages, a potential war with Iran, and further rate hikes looming on the horizon, could react to create a disastrous outcome on inflation and subsequently, the markets. Although, I'm still betting Mr. Bernanke has a myriad of tricks up his sleeve, ready to keep inflation from catapulting into the danger area (don't forget the invisible M3 monster hiding in the shadows).

Our first big clue to the markets resolution will come with the onslaught of quarterly earnings. The first heralds to lead the way will be the four horsemen: Yahoo, Google, Ebay, and Amazon. Considering analysts have lowered earnings forecasts quite a bit, it’s possible that the Internet bellwethers could make their long anticipated comeback. I'll be standing on the sidelines waiting to see the outcome. While you're waiting, go out and get a copy of Taylor’s fine thriller, Paradigm, curl up next to a fireplace and see if the Shepard brothers can solve the mysteries of the Taylor effect.

© 2006 David Greig

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David Greig
San Mateo, CA USA
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