I’ve said for a while now that this bull market will eventually end with issues related to inflation. Last week’s CPI number of 4.2% Year over Year for April is not it. Think where we were a year ago…most of the economy shut down, uncertainty rampant, supermarkets only allowing seniors in their stores for the first hour of the day. It was unprecedented times. So, to have inflation numbers be up (on a one-month basis), of over 4% is not the issue that will likely stop this bull market.
The headline inflation number (at least for the next few months) will most likely look bad, as we compare it to the early phases of the pandemic. Since then we’ve had MASSIVE stimulus, a re-opening with some pent up demand, new push to suburbia from the cities, and all-time high savings rate for U.S. Consumers.
Expect more (a lot more) discussion about inflation. Let’s look at a few reasons why inflation is important to the stock market…
First… Inflation can be the silent killer. It’s the fatty deposits inside the blood of capitalism. You might feel fine when inflations hits, and you may even feel like you’re (financially) doing great, but these fatty deposits build up over time can cause blockages. To use a Buffett reference, if you have enough money to buy 10 hamburgers and you invest those funds in a stock, which you receive dividends to the value of 2 hamburgers, and eventually make a gain on your original investment, but after tax you only have enough to buy 8 hamburgers, then you’ve made no real income from that investment, no matter how much it appreciated. “You may feel richer, but you won’t eat richer,” says Buffett.
Second… There is a tipping point on inflation and its relation to multiples. Simply put, when inflation is low, it’s been acceptable to pay a higher multiple for earnings. As inflation goes higher, the justification to pay for higher multiples dissipates.
*S&P 500 reflected in chart.
The graph shows 2.5% year over year as the tipping point where multiples generally come down.
Third…. Inflation is a bigger issue for bond investors than equity investors. Inflation can generally cause rates to rise, when rates rise the value of bonds that are currently held go down. There is an inverse relationship between yields and bonds (when credit quality is the same). Simply put, no one wants your 2% bond if they can buy a 3% bond, so to get rid of it, you’ll need to discount the price. This can be a particular issue for owners of bond mutual funds that are dictated by a Policy Statement determining the duration of the bond. If you’re a long-term bond manager, then you are mandated to stay in the long end of the bond market. Using the teeter totter example, the longer the duration of the bond, the more it will move with rate movements. The ends of the teeter totter move more than the section close to the middle.
Stocks have an opportunity to appreciate greater than inflation, where bonds do not.
Where to from here?
As I said at the start… I think this inflation number is a short-term blip based more on where we were a year ago, rather than the strength of the overall economy. I believe earnings will be outstanding in the next 12-24 months, that will justify higher prices in equities from here, even with a retracting multiple. However, remember stocks are forward looking, while all the economic readings we get (CPI, PPI, Wage growth etc.) are backwards looking. The headline itself has capacity to spook the market in the short term. Stock markets shoot first and ask questions later!!!!
As far as last week’s pull back…Since 1980 we have averaged a 9% pullback each year. I want you to not only prepare yourself for the possibility of a pullback of that velocity but expect it. The strategy at that stage will not be to run and hide, but hopefully deploy more capital from other asset classes. At least until inflation “really” kicks in.
With that said here’s the Buy/Sell. Have a great week & feel free to call with any questions.
Mick Graham, CPM®, AIF®
Branch Manager/Financial Advisor at Raymond James in Melbourne, FL
Any opinions are those of Mick Graham and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Keep in mind that individuals cannot invest directly in any index. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.