Trying to stifle the inflationary musings of Bernanke

Serious Money: The new chairman of the Federal Reserve, Ben Bernanke, certainly has a way with words. On at least two occasions in his short tenure he has managed to catch the markets by surprise with comments that have spooked already jittery investors.

Both times his remarks have suggested concerns about inflation that have been interpreted as signalling higher interest rates. Equity markets in particular have taken fright on both occasions. Indeed, stocks have probably been more volatile than any other asset class. Bonds markets, arguably more directly affected by interest rates than equities, have been a haven of calm compared to the storm that has been the stock market. What is going on?

Any analysis of short-term movements in stocks and bonds must acknowledge the obvious limitations: by definition, price movements over a few days or weeks can sometimes defy explanation.

Prices just move, devoid of any rhyme or reason. Sometimes, they can do this for very extended periods: think of the stock market bubble of the late 1990s or exchange rates pretty much all of the time. So, when you see those pundits trying to explain the ups and downs of the market, think about trying to explain the results of a coin toss.

But market movements sometimes do have a rational explanation. Is there anything we can identify that underlies the turmoil of the last month? It all started around about the second week of May when we were hit, according to the experts, by an inflation scare. Soaring commodity and oil prices were to blame. Crude oil prices, along with surges in already high copper and other metal prices, finally spooked the stock market.

The trouble with the inflation scare thesis is that it doesn't hold water. The one market most sensitive to inflation, bonds, managed to sail through all of this virtually unscathed. Inflation expectations, properly measured via the bond market, have actually fallen since May 11th, the date when many commentators say that all the trouble began.

Why are stocks so worried about inflation? In the jargon, equities are "real" assets: a generalised inflation should simply boost both revenues and costs in equal proportion, leaving real levels of profitability unchanged.

Investors should look through inflation - indeed, equities should be seen as an inflation hedge. Over time, all this is true.

It is too much of a stretch to ask many investors to look through inflation's shorter term consequences. If pushed, most investors will cite the 1970s as the reason why inflation is so bad for stocks.

Then, the interest rate rises that were ultimately necessary to defeat inflation also killed the economy. Profits collapsed and took stock prices with them.

Business cycles were severe, recessions deep and investors headed for the hills. If we had suggested to anyone at the time that they should look through the inflation problem, we would have had doubts raised about our sanity. But, as we now know, many of those stock price falls represented fantastic buying opportunities.

Stock market volatility has not been caused by just one thing. Inflation worries have combined with concerns over further oil price rises. Up until now, most of the rise in the oil price has had little effect on the global business cycle: causation has been running from booming economies through to the oil price. That's one key way in which things are different this time. But if oil prices rise from here because of, say, problems with Iranian supplies, that's a very different kettle of fish. That's much more like the 1970s. And how does anyone come to a rational view about this sort of thing?

I conclude from all of this that stocks will regain their poise when and if Bernanke stops musing in public about his darkest inflation fears and when we find a reason to stop worrying about $100 (€78) oil prices.

My innate optimism - often revealed in this column - leads me to believe that this is how things will pan out. But getting from here to there could well involve a lot more volatility and, possibly, further bad days for the stock market.

Many stock markets are still up year-to-date (at the time of writing at least!). But the numbers are now into low single digits. Taking a step back from all of last month's volatility, it is sensible to ask what can be expected of equities under "normal" circumstances. The answer is that returns - including dividends - should, for mature markets, be around 6-9 per cent a year. Anybody who thinks that those numbers are way too low shouldn't be investing in stocks. But the returns that we have seen so far this year are entirely consistent with this notion of what is normal.

Stock markets have spawned a thousand clichés. One that comes to mind is the idea that investor sentiment is always extreme and veers between greed and fear. And, right now, people are fearful.

This can be seen in the ways in which markets respond to new information: good news is largely ignored, while bad news is seized on as another reason to sell. In such circumstances, those of us in that dwindling band of equity optimists are likely to see our resolve severely tested.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.