Is it possible the recent year’s rally in the US Stock Market is in part due to a falling dollar and rising inflation, rather than economic conditions?

Consider the following. Many people are ‘bearish’ the US stock market and cannot believe the strength of the creeping uptrend in the US Indexes because they believe a recession is ahead based on various interpretations of economic data and future projections.

Consider also that the US Economy is experiencing inflation readings slightly above the Federal Reserve’s “comfort zone” of 2%, yet economic growth (evidenced by GDP) is slowing, causing some to cry for calls of possible ’stagflation’ ahead.

While this post will not address those issues, consider also the following: The stock market tends to lead the economy by six months, making the market a forwardly anticipating mechanism. The implication here is that the economy will strengthen in the future, yet signs on the ground now are not showing it convincingly.

Finally, consider the possibility that economic conditions are deteriorating, and that the rise from July 2006 to present is due in part by inflation and the declining US Dollar value. The market discounts all known information, which means it discounts these variables as well.

The implication is that, while US indexes continue to make new highs (Nasdaq and S&P excluded), actual purchasing power is declining relative to the new highs in the equity markets. To put it another way, conditions ‘behind the scenes’ are so bad that the inflationary and dollar declining mechanisms built into the stock market are causing the market to rise as a result of the poor conditions, (relative value) while absolute value declines.

Here is an illustration. How would you feel if the US Stock Market suddenly surged 600% this next quarter? Wonderful, wouldn’t you? I bet there would be celebrations nationwide about how wonderful the economy is and how rich we are as Americans and CNBC will be parading all the time.

But what if the inflation rate for the same period was 1,000%? This exact scenario actually occurred First Quarter 2007 in Zimbabwe’s economy. While their stock index made astounding new highs and record-breaking increases, it was a direct result of inflation and little else. Wouldn’t you argue that inflation rates that high indicate a terrible, abysmal economy? So why didn’t their stock market index break to new LOWS instead of record HIGHS? It’s because the market index has to keep up with inflation, and when inflation rises, so must everything else tied to that currency (in terms of purchasing power).

So an apple might cost $1 today and the next month will cost $1,000. Of course, your salary would increase from $30,000 per year to $30,000,000. Would you like to have a salary of $30 MILLION per year? I would! But what if a house cost you $200,000,000? What if a car cost $15,000,000?

Does it make sense now why the Zimbabwe stock exchange gained 600% now? The truth of the matter is that the relative value of the stock market DECLINED precipitously, but you can’t tell that if you’re only looking at the index itself.

The US Economy is no different. While the stock market may be making new highs, is it is partly due to inflation and the declining dollar being factored into the complex mathematics that is the market discounting mechanism.

So while the average American focuses on new price index highs and celebrates, those who look beyond the data realize the meaning behind the numbers and realize we’re in a lot of trouble unless the US Dollar begins to rise and inflation begins to subside.