Stocks reap double-digit returns after inflation peaks, history shows

The euphoria now sweeping through the stock market has strong justification in history: Whenever inflation has peaked, double-digit gains have followed.

The S&P 500 Index, which has shed 18% in 2022, surged 4.7% on Thursday after the rise in the consumer price index cooled in October by more than forecast, putting the index on track for its best day since December 2008. Meanwhile, the Nasdaq 100 Index soared 6.1%. Both indexes are on pace for their best sessions since April 2020. 

Not surprisingly, U.S. stocks struggle while inflation rises, but not after it peaks. 

Since 1950, the S&P 500 has posted a total return of 13% on average over the next 12 months following 13 major inflation peaks, according to Jim Paulsen, chief investment strategist at The Leuthold Group. In the 10 instances where the index rose the year following a substantial inflation spike, the total return for the S&P 500 jumped by an average of 22% over the subsequent year, data from Leuthold show. 

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While nobody knows whether the bear market is nearing its end or if it is due for another leg lower, Paulsen noted that "bad news" has seemingly affected the stock market far less since the summer than in the first half of 2022. That's come with cyclical sectors and small-cap stocks soundly beating the S&P 500 in recent months, he added.

For U.S. equity markets to see comparable gains, stubbornly high inflation rates must fall at a faster clip, though investors may miss out on those hefty gains if they wait too long since markets tend to begin rallying from bear market lows well before economic data bottoms, according to Jimmy Lee, chief executive of The Wealth Consulting Group.

"Investors really need to be positioned well in advance of the Fed signaling a pause because the stock market will likely be substantially higher from here by the time those words come out of Fed Chair Powell's mouth," Lee said. 

In post-World War II cycles when consumer price increases topped 5%, the benchmark's average return six months, one year and two years later was 5%, 12% and 15%, respectively, according to Strategas Research Partners.