“We are not bullish or bearish – we are on process.”
– Geremy van Arkel, CFA

Valuations Matter

TINA! There is no alternative. This acronym is a reference to the idea that when savings rates are zero and the bond market only offers a pittance of return, investors will view risk assets as the only game in town.  However, 12 years into a bull run for U.S. stocks, one might be hard pressed to imply that U.S. stocks are reasonably priced at these levels. And, now with inflation heating up, we can add commodities into the mix of assets with prices approaching multi-decade highs. We are left with current price levels for stocks, bonds, real estate, and now commodities all implying lower future expected returns based on our analysis. Maybe the new acronym should be TINAA – there is no alternative to the alternative.

Undoubtedly, many investors today must be looking into their magic hindsight rear-view mirrors and hoping for the parabolic returns of yesteryear to continue. Whether it be return chasing or TINA, investors have poured 20 years’ worth of net asset flows into the stock market this year. But, for this quarter, stock prices were muted.  What gives? Maybe there is only so much hot air that can be blown into a balloon?

Of course, valuations are not just about prices. There are two sides to the valuation coin. The merit of an investment must also be considered, often stated as earnings, yield, sales, book value, rents, etc. The price to earnings ratio (P/E) is the most common valuation measure for stocks. While current U.S. stock prices are – by most measures –high, earnings have been surprisingly strong.

When a balloon expands, it expands in all directions – all sides of the balloon benefit. As stock prices rise, so too does the economy benefit. And what an economy we have had recently. Earnings have followed suit, posting positive surprises quarter-after-quarter.

Then again, let’s get back to why has the energy in the stock market seems to have waned? My guess is that investors are now questioning the trajectory of earnings. Whether it be wages that companies now must pay, a lack of workers, a shortage of supply chain inputs, or inflationary pressures, companies may be facing headwinds that can dull their earnings growth rates. And the “market” tends to price earnings changes long before they actually occur, or at least that is how it is supposed to work.

The hanging question is, can this earnings growth continue at this pace to drive stock prices ever higher, or has the easy recovery money already been made?

Key investor takeaway

While I waxed and waned up there, valuations do matter. The problem is that over short periods of time, valuations are typically not indicative of future returns (nor is past performance indicative of future returns).  For equities, the idea that stock returns will be higher when the current P/E is low and lower when the P/E is high, is not linear for return periods less than about 10 years. In other words, for any given 5-year period time, stocks can act both rationally and/or randomly. However, wait long enough, and the valuation connection often emerges. This is akin to my declaration of “call me in 10 years and I will tell you if valuations were a good predictor of returns”.

Investors often don’t want to wait 10 years for capital markets to act rationally, or for valuations to ring true.  Returns in the short run often drives investor asset flows. Throw in a big year, and the magnitude of returns acts like a magnet for capital.

The second assumption of the current high prices for U.S. stocks is that some investors may infer that the U.S. stock market is just about to crash. However, valuation data does not suggest this. Just because most market corrections have occurred while valuations have been historically high, does not mean that all periods of high valuations have led to market corrections. What the data suggests is that over longer periods of time, high current valuations lead to lower future returns, and vice versa.

Alternatively, market corrections in the modern era have usually been driven by surprise events or black swans, think COVID-19, or the Financial Crisis. The Tech Wreck of the early 2000s is the exception to this rule though. We recognize that there has been a general rise in the P/E for the U.S. stock market for the past 20 years, and for most of those years, the P/E has remained historically high. John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent.”

What should investors do about these high asset prices?  Probably nothing. The problem is TINAA. There is no alternative, and now no alternative to the alternative. Prices are high nearly everywhere, and likely to a similar degree across asset classes. But holding cash is losing to inflation at a rate of 5% a year.

Those with savings would, it seems, by necessity have to be investors. However, that doesn’t mean that investors have to act like speculators.

Inflation – More Persistent Than Transitory

The big surprise this year remains inflation. The latest CPI-U year over year inflation print is 5% for the 12 months ending August 2021, and this inflation doesn’t seem to be retreating any time soon. Regardless of whether this rise in prices is lumpy – influenced by the sectors or energy, chips, or used cars – it does appear that most of us are witnessing pockets of inflation in our lives.  And, inflation can be contagious, inflation in one area, often spills over into others.

The Fed has proclaimed that this current bout of inflation is transitory and that it will soon retreat to the old “Slow and Low” levels of the pre-COVID-19 era. The thesis backing the transitory camp is that rolling supply chain disruptions are occurring due to COVID-19 shut-downs, as workers stay home and factories are shuttered. It is believed that once COVID-19 subsides so too will the supply disruptions. However, this simple thesis doesn’t explain:

1. A general lack of workers – even in industries not shut down or in countries that didn’t provide stimulus checks
2. Rising wages – which many economists believe is a basis for persistent inflation
3. Cost of housing – whether it is rents or property prices, housing is bordering on unaffordability
4. Energy prices – rising energy prices, despite decreased transportation
5. Rising commodity prices – almost all commodities are in short-supply and are facing heavy demand pressure
6. And maybe once COVID-19 is under control, the economy could be even stronger

These factors are evidence of a coordinated demand spike. It appears that most of the world is experiencing a booming economy, independent of COVID-19. This surprise demand spike is coinciding with what I call flat footed production. Companies that produce and manufacture goods had become complacent during the “Slow and Low” and had borrowed and spent to buy back their shares as opposed to increasing production capacity.  What we are now witnessing is a demand spike coinciding with a capital expenditure explosion as businesses scramble to increase manufacturing.

All of this shouldn’t be said without my constant reminder that asset prices seem to drive the economy. Why a demand spike? Maybe it is a simple as; it is because asset prices are high that everyone feels wealthy and spendy.  Alternatively, any retreat in asset prices could quickly squash inflation.

Key investor takeaway

One of the most effective way to hedge against inflation has been to invest in commodities. Historically, and logically, when inflation has occurred, this general rise in prices has coincided with a rise in input prices (commodity prices).  Conversely, inflation negatively impacts the returns for fixed income instruments. Finally, despite all the speculation that stocks can be a good hedge against inflation, this relationship is murky. In general, stocks can perform well if inflation is measured and predictable, but unpredictable inflation or inflation that hinders the economy may be bad for the prospects of stock ownership.

So, should you sell your bonds or buy commodities? Not so quick. Commodity prices have already risen considerably since April 2020 and will likely require inflation to accelerate from here to potentially offer significant gains. Further, commodities can be highly volatile, and have historically been extremely hard to time. On the other hand, to sell bonds would ignore their hedge value against economic slowdowns or worse, a decline of heated stock prices.  To do both – buy commodities and sell fixed income – would tend to greatly increase the downside exposure of a portfolio. To do so now, would be arguably questionable timing.

Again, inactivity may not be a bad thing here. A wait and see approach is not the same thing as ignorance to the issue.

The Fed Has to Act. If Not Now, When?

The asset prices of stocks, bonds, real estate, and now commodities all seem to be hanging around multi decade high valuations levels. Inflation has blasted past the Fed target rate of 2% year-over-year CPI-U, and now it appears that this inflation may be more persistent than once thought.  Yet, the Fed is steadfast, anchoring the Fed Funds Rate at 0% and maintaining asset purchases in the open market – albeit at a tapered pace.  They are belligerently adhering to the decade old playbook from the post 2008 “Slow and Low” era.

What are they thinking?

Key investor takeaway

If the Fed doesn’t move here on asset purchases or the Fed Funds Rate, brace yourself for more expected inflation. If the Fed does completely stop asset purchases and raise the Fed Funds Rate, be prepared for probable asset price volatility.  All asset prices are subject to pressure under a tight Federal Reserve regime. Caught between the devil and the deep blue sea. Is this what they call the Keynesian End Point?

That’s what it “feels” like at least. However, feelings are “truthy” not “fact”, and how this unfolds will likely take us down a path that is somewhere in the middle of extreme outcomes.  History implies, that measured and slow central bank tightening doesn’t have to be a bad thing. Most tightening regimes in the modern era have occurred during a strong economy – like what we are experiencing today – and these regimes have not been particularly damaging to asset prices. So, what are you waiting for Mr. Fed?  Carpe Diem.

Carry-on.