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Inflation Barometer and
Inflation vs. Deflation


The Inflation Barometer

The Inflation Barometer, shown in Chart 1, is our most accurate model, having identified the majority of business cycle swings in industrial commodity prices since the 1950ís at a relatively early stage. Changes in commodity prices are perhaps the most important influence on bonds. Consequently, this indicator has provided us with valuable advance warnings of reversals in price swings in the bond market.



 Inflation vs. Deflation

One of the most important aspects of business-cycle analysis from the point of view of optimum asset allocation is the relationship between inflation and deflation. During the middle to late phase of the recession and the early stages of the recovery, deflation sensitive assets outperform inflation sensitives. Examples of deflation sensitive assets would include bonds and interest sensitive stocks such as prefereds and electric utilities. Inflation sensitive assets would embrace so called earnings driven stocks such as basic industries, steel, chemicals, mines, and energy.

It is important to note that itís entirely possible for both inflation and deflation sensitive assets to be rallying together in the early phase of an equity bull market. What weíre concerned with is the relative performance.

There are a number of relationships we follow to try to get a fix, not only on emerging relative strength trends, but also to act as further confirmation for our Stage analysis. For example, if a number of ratios are indicating a superior performance for deflation-sensitive assets, this suggests we are in the early to middle stage of the business cycle. Conversely, if inflation sensitives are beginning to emerge, then we have a good idea the cycle is in a more mature inflationary phase.



Chart 2 - Government Bond Prices vs. CRB Raw Material Index


The relative strength relationship between bonds and industrial commodities lends itself very nicely to KST analysis because the cycle is continually moving from an inflationary to a deflationary phase. In this respect, Chart 2 shows the ratio between government bond prices and the CRB Raw Industrial Material Index. As a general rule, the long-term KST experiences very smooth and deliberate swings between the bull and bear phases of the cycle. When both the KST and the Ratio are above their moving averages, a relative bull market favoring inflation sensitive assets is signaled and vice versa. We can also look to the position of the KST as a guide to the prevailing stage of the cycle. For instance, if the KST is overbought and starting to roll over, itís likely the inflationary part of the cycle is giving way to the deflationary part.


 Chart 3 - Inflation vs. Deflation Sensitive Groups and a Long-term KST


Chart 3 shows another inflation/deflation ratio. This one is an internal stock market measurement since it pits an index of inflation sensitive-equities to deflation-sensitive ones. Inflation-sensitives embrace stock groups that do well when commodity prices are rising such as mines and energy. Deflation stocks put on a superior relative performance at the beginning of the cycle as the economy is terminating a recessionary phase. They include interest-sensitive stocks such as electric utilities and financials. If you compare this ratio to the ratio between bonds and commodities you will see the cyclical swings are reasonably consistent with each other.

Excerpted from "Understanding the KST and Asset Allocation" 

Don't forget to check out the glossary - it has over 300 technical terms! 

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