This under-the-radar trend may provide investors with relief from runaway inflation fears

A longtime market bull sees an under-the-radar trend that should calm runaway inflation fears, and it has nothing to do with Federal Reserve policy.

According to The Leuthold Group’s Jim Paulsen, private money coming from individuals and companies has been acting as a “very encouraging” market mechanism to help curb inflation.

“We make decisions about whether we save or spend. We make decisions on whether we borrow money or not. And, those all affect the rate of growth of the money supply,” the firm’s chief investment strategist told CNBC’s “Trading Nation” on Monday. “While we’re still debating when the Fed may start tapering … the reality is the money supply in this country has been tapering now for the last four months.”

Paulsen, who oversees about $1 billion in assets, highlights the trend in a special chart. It shows the relationship between consumer price inflation and money supply since 1990.

“The real M2 money supply [total amount of dollars held by the public] peaked at the end of February year-on-year at 26% rate of growth,” Paulsen said. “As of the end of May, it’s down to about 8.5%, and it’s probably lower than that when the June numbers come out.”

Paulsen estimates it dropped the rate of growth and real liquidity by about a third.

“When you overlay that real money supply chart on top of the inflation rate, it’s not a perfect relationship,” he noted. “But there is certainly a strong relationship where periods of significant declines in the money supply often lead into the future to slower rates of inflation.”

What a difference two months makes.

On “Trading Nation” in April, Paulsen ranked runaway inflation as his biggest risk to the market and put the probability of runaway inflation at around 40%. 

‘Yields are about done going down’

Despite his current optimism regarding mitigating inflation risks, Paulsen still expects the benchmark 10-year Treasury Note yield to climb higher. Yields closed at 1.48% on Monday, down more than 11% over the past three months.

“Yields are about done going down. We’re going to continue to get really strong growth reports,” he added. “We’ve got another fiscal package coming, and I think that’s going to rejuvenate inflation fears and strong real GDP growth that’s going to push yields back up towards 2% by the end of the year.”

His expectation: Higher yields will create headwinds for stocks, particularly for growth names, in the year’s second half.

“People worry about monetary tightening, and the market goes through kind of a pausal period, and I think we’re in that right now,” said Paulsen. “Oftentimes during these periods we have corrections, and I think we may get one of those later this year as well.”

He predicts the S&P 500 will hit 4,500 before slumping to 4,100 by year-end. On Monday, it closed at 4,290.61 — an all-time high. It’s up 14% so far this year.

“[If] the market ends flattish or a little down from where we are now, we’re going to go into 2022 with a stock market, with a trailing P/E multiple, that’s undervalued relative to its history back to 1990,” Paulsen said. “It sets up the next leg of the bull.”

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