We hear two major themes in the questions being asked by clients these days: is the stock market heading for a correction, and what will inflation do? While we’ve written on both several times, these are perennial issues, and so we devote this short piece to a quick review of both topics.
First, let’s stipulate and agree to two things: the stock market does not always go up, and hitting new “highs” is not a warning sign that the market must go down. The first point shouldn’t need much explanation, but it’s important to acknowledge this reality. The chart below, showing the S&P 500 over just the last five years, shows roughly 8 market “highs” from January 2018 through February of 2020, when the Covid economic shut down hit. The Covid recovery generated its first new market high in August of 2020, with nine or so market highs afterward up through today (July 15, 2021). In between were plenty of drops. The stock market does not always go up, even if it is trending upward over a long period.
The chart also dispels the second concern that a “high” is a warning sign. Some of these market highs were followed by a dip, but several were followed by a subsequent high with no dip in between. There is no correlation between the stock market’s position at any point in time with its future direction – zip, nada, zero!
The stock market is simply a place where all owners, or potential owners, of stock, express their opinion about the worth of those stocks in the future. And the value of those stocks is the value (measured in today’s dollars) of the future profits the companies are going to produce. Is it a perfect prediction? Never, but it’s usually very accurate over the long term.
We determine the value today of these future profits through a technique called “present value” calculations, which rely on an interest rate assumption to discount the future profits back to today’s value. The higher the interest rate used, the lower “today’s” value is for future profit.
We promised to keep this article short so that we won’t delve into the underlying economy. Suffice it to say that all the signs – industrial, commercial, retail, residential, consumer – point to continued strengthening. The key question in today’s very low-interest rate environment is what effect those rates will have on determining the “present value” of future profits.
The most common interest rate used to discount future profits is the 10-year Treasury. At today’s low rate of 1.31%, this present value calculation would suggest that the S&P 500 is undervalued by 48% or so. If nothing changes, we would expect the market to climb another 45%.
If interest rates rise to the point where the 10-year Treasury is 2.4%, then the S&P is undervalued by 20%. In other words, there is just no justification for saying any of the following:
- The stock market’s “high” level means it must decrease
- A correction is imminent
- The stock market is overvalued
The market is volatile because it is the compilation of all the buyers and sellers making their individual decisions. Tomorrow it might go up, tomorrow it might go down, or tomorrow it might go both up and down in the course of the day. We just don’t know – nobody does – but we focus on the longer-term trends, which remain strong.
The most logical question following the discussion about company profits and the stock market is whether there is something that can influence them. The answer is in the realm of government actions, one of which is inflation.
Inflation impacts both the future level of profits and the interest rate we use to discount the future to determine the present value. The Wall Street Journal reported on Wednesday, 7/14/21, that “inflation escalated at the fastest pace in 13 years” so this is a real issue now. Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon,” which means that as the government creates more money, it depreciates the value of the money.
A simple, common-sense example illustrates. If the price of oranges is $2/pound today, and suddenly you double the amount of money people have to spend, then people will use the extra money to drive up the price of oranges. The price of oranges will climb to $4/pound.
As inflation sets in, several potential problems arise; we say potential because the rate of inflation determines how severe the problems can be. We wrote at some length about this in our April 1st, 2021 commentary, so we’ll just recap here.
- As interest rates rise, they decrease the present value of future profits
- Prices can rise unevenly, causing artificial “winners” and “losers” in the economy
- Company managers face greater difficulties trying to adjust to keep profit levels climbing
- Company managers can overcome these challenges and actually grow profits over time
Again, to keep this article short, we’ll recap our lengthier comments from April 1st, 2021. Those companies which can quickly alter their pricing structure to accommodate cost increases will be better able to maintain and grow profit levels. We emphasize stocks of companies that can make these adjustments.
Stronger managers will be better able to make these adjustments than weaker managers. We emphasize stocks of companies with strong management teams. Companies with competitive advantages relative to their competitors or to alternative products will be able to maintain profit margins. We emphasize stocks of companies that have strong competitive “moats.”
Stocks fare better than bonds during inflationary times, but bonds still provide much-needed diversification benefits to portfolios. We do not try to time the market to move out of bonds and into stocks, or vice versa.
Short-term bonds will weather inflation better than long-term bonds. We tactically move the bond allocation from the long-term side of the spectrum to the short-term side. In addition, we emphasize bond managers who have the latitude to alter their portfolio (active vs. a passive manager) in reaction to interest rate movements.
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First and foremost, we remain confident in the economy’s underlying strength and the stock market’s viability. We continue to affirm the long-term benefit of proper diversification and professional management in the portfolios we oversee. We are not predicting a return to the high inflation and stagnation years of the late 1970s, but we are realistic in assessing that there will be challenges ahead.
In that vein, we remain committed to helping clients achieve their financial goals and to implementing wise strategies and tactical moves to meet both long-term performance goals and near-term liquidity and stability goals. We live in “interesting times,” but we don’t view that as a curse. It’s simply an opportunity to find ways to continue moving forward.