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Fourth Quarter 2021: The Download

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Stalemate 2022? High asset prices vs. inflation

Geremy van Arkel

“While investors appear euphoric about the strong economy and ever rising asset prices, the headwinds of inflation and tighter Fed policy may stall prospects for both stock and bond prices in 2022.”
– Geremy van Arkel, CFA

Inflation – Will it be a problem?

While the Fed governors appear to be sitting on Zoom bemoaning whether to accentuate the word “persistent” over “transitory”, out here in the real world, we are all feeling the effects of inflation. This long dormant economic dragon has awoken and is lumbering out of its cave. And, historically, when you wake the dragon, she doesn’t go back to sleep too quickly.

Debate amongst yourselves if you care to. Is inflation occurring due to a decade of unprecedented globally coordinated stimulus, repression of interest rates, COVID-19, worker shortages, supply chain congestion, demographics, or a wage price spiral?  Wait, isn’t all of this happening at once?

I have written and presented extensively about inflation over the past year, but here and now, I want to emphasize one point. Historically, rapidly rising inflation has set into motion a chain reaction of events that have often led to recessions.

You can’t unsee it. Inflation cycles precede recessions.

CPI for Urban Consumers

Key investor takeaway

  • The occurrence of inflation can set a cycle of events in motion which historically has often ended with a recession.

What can the Fed do now?

With the Fed Funds Rate pinned at 0% and inflation near 6% (12-month trailing Consumer Price Index for All Urban Consumers (CPI-U)), it would appear likely that the Fed will raise interest rates and taper/end asset purchases in 2022.

CPI for Urban Consumers & Fed Funds Rate

It also appears that the Fed is way behind the curve on this inflation cycle. A quick study of history would suggest that the Fed has historically been proactive in keeping the Fed Funds Rate near or above the rate of inflation. However, since 2008, the Fed Funds Rate has been pinned at or near 0%, which is now below inflation by the widest margin in history.

It is not unprecedented for central banks to appear paralyzed in the face of inflation. Central bankers should know that tight and restrictive monetary policy can lead to asset price disruptions and recessions. To raise interest rates and end asset purchases is a headwind for asset prices and ultimately the economy, but to let inflation spiral out of control is a far more dangerous proposition.

Key investor takeaway

We believe the Fed is behind the curve on reaching to inflation.

  • It is likely that asset purchases will slow or end and for the Fed Funds rate to increase.

S&P 500® Index – Priced for perfection?

Warren Buffett once said, “Never bet against America.” Over the past decade, the S&P 500 Index has performed true to these words. The S&P 500 has returned about 17% a year over the past 10 years, more than doubling the return of most indexes representing other major asset classes. And rightfully so—the S&P 500 is a quality index that has experienced solid earnings growth, represents the largest economy in the world in terms of market capitalization, and is comprised of many of the most successful companies in the world—maybe ever. Has there ever been a Google or an Amazon before?

Growth $100 Major Equity

Lately though, when I reference the performance of the S&P 500 (or similar U.S. Large Cap stock indexes), I can’t help but think about those Los Angeles real estate reality T.V. shows that I shamelessly watch. To use an analogy of real estate as an example for stock prices, “Yes, I can see that the house is absolutely incredible but is $37 million dollars a reasonable price?” Will the buyer of that house – at that price – make any money in the future, and how much risk are they taking on?

When investing in just about any asset, this same simple valuation equation exists—there are the characteristics and quality of the asset, and then there is the price we all have to pay. By all measures, many of the companies that make up the S&P 500 are standouts on the global scale and in terms of history, but what price should you pay to ensure you continue to experience a solid return with reasonable risk?

Historic Shiller S&P 500 P/E Ratio – At what price?

Historic Shiller S&P 500 P/E Ratio

The above Shiller P/E (Price to Earnings) chart characterizes the price of the S&P 500 in reference to the trailing 10-year normalized earnings through history. We can debate all the merits of S&P 500, but this depiction clearly shows that in a historic sense, U.S. large cap stocks are expensive.

Although just because U.S. large cap stocks have greatly outperformed other competing asset classes, and are priced at lofty historically high valuations, that does not imply that a stock market crash is imminent. After all, there are several tailwinds for U.S. equities, including:

  • Earnings are strong
  • The economy is strong
  • TINA – In a zero percent interest rate environment, There Is No Alternative

Rarely do stock markets fall apart due to valuations alone, one would have to look back to The Tech Wreck in the early 2000’s for the last meaningful occurrence of that. More often, in the modern era, stock market risk events are unprecedented surprises (black swans). However, leadership can shift ever so subtlety, and often when investors least expect it.

What could break this trend?

In the early 2000s, when S&P 500 leadership wanned, there was severe damage to the technology stock sector, but there were also winners. In the years following The Tech Wreck, two new economic outcomes entered the landscape: inflation and rising interest rates.

Post “Tech Wreck” when inflation and interest rates were rising

Growth $100 Major Equity

Not to say that history repeats, but it can rhyme.  Today, the breezy tailwinds of low inflation, low interest rates, and abundant stimulus have never appeared more vulnerable to a change. Not only have these tailwinds petered out, but they are now headwinds. But, what, me worry? The trend is your friend…until it is not.

Key investor takeaways

  • Investors are often risk seeking in the face of strong past performance.
  • Investors rarely feel like they own enough of the top performing asset.
  • However, what has performed well in the past doesn’t always continue.
  • Don’t go chasing – Most of the managers or investments that have outperformed over the past 10 years simply have more U.S. equity.

 Being a downside risk manager, we are fearful when we believe others are greedy. Thus, the three key points for the quarter could be perceived to be a rather dour outlook. However, please do not confuse tempering optimism with outright pessimism. Across the global landscape, expected returns differences between asset classes present positioning opportunities, and small adjustments to the asset allocation framework can result in significant added value at this time. Alternatively, though, simple large U.S. stock and aggregate bond index strategies could be in for quite a challenging time when the trend is no longer your friend.


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