Inflation, Market Valuations, and Year End estimates.
After years of fiscal and monetary stimulus, inflation is now the great concern. Inflation increases stock volatility. It causes the cost of labor to go up. It eats into everyone’s purchasing power. It crushes the standard of living of those people living on a fixed income. It causes company price to earnings ratios to drop. And to stop it the Federal Reserve Board (Fed) must raise interest rates-which in turn takes home prices out of reach for new home buyers. It also puts the political party in power in a bind since you cannot spend your way out of it since added spending only increases inflation.
With political pressure at their back the Fed plans to raise interest rates possibly four times over the next 4-6 quarters. In a bold double move the Fed also plans to cut back its multi-trillion-dollar balance sheet. This means rather than supporting the bond market, the Fed will sell bonds. No doubt some pain will be felt as the Fed has supported the markets for years. This time it will be different. Investors will more harshly judge company metrics inclusive of pricing power and the quality of balance sheets.
Yes, social security is indexed to inflation. Most people view the upcoming increases as less than enough to keep up with the true impact of inflation. For retirees clinging to the notion that they can remain in the middle class, inflation and taxes are killers since the cost of medical care, housing, food, and fuel keeps going up, spurred by supply-chain disruptions and labor shortages.
With mid-term elections just months away, concern is growing that the Fed may overstep interest-rate hikes-thereby sending the economy into a sudden pullback.
So, who gets hurt more during periods of inflation, stocks, or bonds? The answer: bonds. Analysts have noted recently that bond investors are more worried today than they have ever been about the Fed getting close to tightening monetary conditions. This is going to happen. The bond market has already begun to price in higher yields and lower liquidation prices. Such periods open-up the possibility of parallel markets in which, while stocks zig zag their way upward, investors will observe both stocks and bonds decline simultaneously. Just now economic growth is poised to slow near term. A slowing will cause the Fed to slow the pace of projected tightening, however, this may well prove to be temporary. If this happens a pause in bond-yield momentum would likely cool cyclical stocks (e.g., financials) and perhaps make the recent selloff in large-cap growth stocks a short-term buying opportunity. For this reason, I have raised cash somewhat to take greater advantage of pullbacks.
Fortunately, and importantly inflation is not the only metric to value stocks. Starting in February, investors may again enjoy another colossal earnings season. If another good earnings season is combined with a pause in yield pressures and decreasing Fed fears, it could produce another broad-based stock market rally. When investors and the Fed are all worried about overheating at a time when there is more evidence of solid earnings gains, a bit slower economic growth, and a pause in yield pressures, it has the potential to produce a dynamite rally. We shall see.
For now, several large investment firms are predicting the Federal Reserve Board will raise rates four times in 2022, starting in March. Will this cause both stocks and bonds to plummet? Historically, if real earnings are growing the market can neutralize rate hikes.
It’s when rate hikes are upon us and corporate fundamentals are poor, that damage occurs to the stock market. Of the 61 months when the Fed raised the funds rate while the S&P 500 real earnings per share (EPS) also increased, the S&P 500 posted an average annualized price gain of +9.7% and experienced a monthly loss just 43% of the time. Fed tightening in the face of solid company performance is not a reason for investors to shy away from the stock market. So, the issue is earnings per share, not rate hikes due to inflation.
At present, a consensus of analysts expects S&P 500 real EPS growth of about 10% in 2022. At the same time, although inflation is expected to stay elevated, the annual pace of inflation is expected to ease to 4.5% for the year and moderate to 2.8% year over year by the end of 2022. If accurate, that implies S&P 500 real EPS are poised for another year of gains to some $260 in earnings. The market is currently trading at some 21 times earnings. So $260 times 21 would result in a year end S&P 500 value of some 5,460. However, if inflation does not abate expect price to earnings ratios to decline. In this case a multiple of 19 would result in 4940 and a multiple contraction to 18 would produce an S&P 500 read of 4,680.
Historically value stocks outperform when a stock market correction is upon us due to slowing profit margins. As we are currently overweight value stocks this is assisting in maintaining account values while lowering asset allocation volatility.
Thank you again, for your continued faith and trust in all we do for you.
Vaughn Woods, CFP, MBA
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0270.