Investor Essentials Daily

We aren’t out of the inflationary woods yet

September 25, 2023

If you just looked at inflation as a straight line, things look pretty good. 

Here in the U.S., Inflation has been below 4% for three straight months. Considering the Fed’s target is 2%, that sounds pretty good. 

However, the Fed thinks the easy part is behind us.

Earlier this week, Fed Chairman Jerome Powell announced interest rates would stay put between 5.25% and 5.5%, which is a 22-year high. 

The Fed wants to reach target inflation of 2% by 2026, and they are not going to lower rates until they see “convincing evidence” that things are improving.

In fact, Powell hinted that one more rate hike could be on the docket this year. 

As we’ll talk about today, this news has to hurt the stock market. It’s just a matter of when.

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Stocks measure the value of a company’s future cash flows. 

That’s why you hear Wall Street analysts talk about using discounted cash flow models to calculate how much companies are worth. 

All they’re doing is predicting how much money a company will make in the future. Then, they “discount” those cash flows back to a current value based on how risky or expensive it will be to generate those cash flows. 

It’s no surprise that if interest rates are higher, companies’ costs go up. That, in turn, makes future cash flows less valuable.

The other way to think about valuation is how much you’re willing to pay for a company’s earnings. This is all a price-to-earnings (P/E) multiple represents. 

Again, if a company’s future earnings are more valuable, it makes sense that investors would be willing to pay more for them. 

That’s why low inflation and a low tax environment produce the best stock market periods. 

Before 2022, we had the best possible combination of factors to drive the stock market higher. 

Inflation and interest rates were low. That meant companies had lower costs, and their future cash flows were expected to have more value. 

Plus, investors’ tax rates are low. Long-term capital gains taxes are still capped at 20%, which is far lower than they were decades ago. 

So, companies were earning more cash flows (thanks to lower costs), and investors kept more of their investment money as gains. 

Now that inflation and interest rates are expected to remain high, that’s going to hurt valuations. 

We’ve kept track of over 100 years of the relationship between inflation, taxes, and price-to-earnings multiples. 

As you can see below, valuations are highest when inflation is low or even negative and taxes are low too. Take a look at the blue segment. Before inflation took off last year, we were in the low tax bracket that yielded an average P/E multiple of 20 times.

Investors have gotten used to that environment. It’s basically what we had straight since the Great Recession ended.

However, the Fed is clear. Inflation isn’t going back to 2% overnight. In fact, last month, it rose from 3.2% to 3.7%. 

That means the market shouldn’t be valued at 20 times. Rather, it ought to fall closer to 14 times.  

And yet, with this year’s market rally, the stock market is valued at about 25 times as-reported P/E. That’s higher than it should be in any market environment. 

This is a damning signal for stock investors. As the market finally realizes that inflation and interest rates are going to stick around for a while, valuations are bound to drop. 

Certainly, not every stock is doomed. And in the long-term, the stock market is still the best place for investors to put their money. However, over the next several months, we expect investors to wake up to the looming risk. 

That’s going to lead to huge selloffs in the stock market. At the same time, when one market panics, they all tend to move in tandem. 

As we saw last year, when the S&P 500 fell about 20%, bonds also fell about 13%. 

And yet, with interest rates looking to be higher for longer, we think stocks have further to fall, while high-yielding bonds could be a genuinely viable and potentially safer option for investors.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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