These are the stocks to own as inflation starts to slow

Jeffrey Gundlach, the CEO of DoubleLine Capital who is often referred to as the “bond king,” is now warning that inflation could hit 10% this year.

Nevertheless, sometime later this year or next, inflation almost certainly will be running at a much lower rate than it is currently. The Philadelphia Federal Reserve Bank reports that the consensus expectation among a large group of professional economic forecasts is for inflation in 12 months’ time to be below 3%.

The inflation-forecasting model from the Cleveland Federal Reserve Bank, which is based on a number of inputs such as Treasury yields, surveys of professional forecasters and inflation swaps, is projecting that inflation in 2023 will drop back below 2%.

If these models are even close to being accurate, then inflation will be dropping by as much as 4 to 5 percentage points from currently levels over the next 12 to 18 months. The stocks you therefore might want to consider investing in now are those that tend to do best when inflation is slowing. It will be too late if you wait until after inflation has come down.

Unfortunately, from a statistical point of view, there is little historical data to go on. Only 1% of months over the past six decades were ones in which the CPI’s trailing 12-month change was at least 5 percentage points below where it stood a year previously. So if we see a decline in inflation of this magnitude in the next 12 to 18 months, we’ll be sailing in largely uncharted waters.

To get a more comprehensive picture of what kind of stocks should do well when inflation is declining, I subjected different stock-picking styles to a number of econometric tests. The ones I analyzed included growth, value, small-cap, large-cap, high momentum and low momentum, among others. Only if a particular style has consistently reacted in one way when inflation is rising and the opposite way when it is declining did I consider it of potential interest for a declining-inflation environment.

Based on data back to 1963, only two such styles emerged: Small-cap and low momentum. Specifically, I found, small-cap stocks tend to outperform the large-caps in declining-inflation environments, and low-momentum stocks tend to outperform high-momentum stocks.

This helps explain what we’ve seen recently: The Russell 2000 Index
RUT,
+0.75%,
a widely used benchmark for the small-cap sector, hit its bull-market peak in early November, and has been declining ever since.

That peak came as inflation was heating up, and well before the Ukrainian crisis was front and center in investors’ minds. It would therefore seem that rising inflation is largely responsible for the index slipping into official bear market territory in late February. My analysis suggests that the opposite should occur when inflation declines significantly.

Not all small-cap stocks will do well, of course. To construct a list of stocks that are worth considering, I mined my database of stock recommendations of the top-performing newsletters I monitor.

The stocks in the table below are those that currently are recommended for purchase by at least two monitored newsletters, whose market-caps are no bigger than the largest in the Russell 2000 Index, and which historically have exhibited a tendency to do well when momentum strategies are struggling.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.