by Bruce Fenton

Despite a consensus opinion among market followers that we are in for another round of Federal Reserve interest-rate hikes, the current year’s outlook, and continuing for the next several years, is “all systems go.”

Driving this are the economic forces of continued growth of the U.S. economy at a sustained and healthy pace, coupled with strong global deflationary forces that will act to keep wholesale and retail prices down, thus curbing inflation and the Fed’s need to make dramatic rate increases.

The importance of inflation to stock market investors cannot be overstated. Profits, interest rates, and inflation are the fundamental variables in the pricing of stocks. If profits continue to grow, the future value of a business (as represented by stock ownership) grows. Therefore, investors should be willing to pay more for the stock.

But the future value of those business earnings must be related back to a present price. If inflation in the future robs the purchasing power of earnings, or profits, the stock is less valuable today. Conversely, if inflation falls and the earnings of the business buy more, the stock has a greater value today. If there is no inflation, the stock price should stay the same.

Understanding this principle, it is easy to see why some traditional investors who looked only at today’s lofty price-earnings ratios could conclude that stocks are overpriced. However, if they had factored in lower inflation, they might have been more willing to pay today’s stock prices.

The Federal Reserve’s role is to attempt to control inflation by controlling short-term interest rates. If the Reserve can cool an overheated economy by raising short-term rates, the long-term outlook for inflation (as measured by market expectations priced into falling long-term bond yields) becomes positive for the markets.

The Fed doesn’t have to shoulder the entire burden of controlling inflation. A number of other factors impact price direction. First, there is growing foreign competition, spurred on by a decade of world capitalism. This competition makes it difficult for businesses to raise prices.

Second, domestic competition has intensified as buyers have more power, thanks to the Internet, to shop for lowest prices. Lehman Brothers economist Stephen Slifer calls the impact of the Internet on pricing “the most deflationary event of our lifetime.”

With foreign competition breathing down their necks, and consumers everywhere able to shop for the lowest prices, how can the great companies of our country survive and continue to employ our workers and produce profits? In a word: “Technology.”

By becoming more efficient and growing their markets, businesses can compete in a falling price environment. Technology has increased productivity and made this possible. Businesses can exercise the same competitive strength as buyers, which their own customers use against them. For example, by using the Internet to shop for lowest-price supplies, businesses can achieve cost savings.

The need to be more efficient and competitive will give rise to an evolution of larger businesses. Small businesses will become incubators for technology and new solutions, but many will lack the resources to compete on a global scale. Their ideas and solutions will be consolidated into larger companies with the resources to compete.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.