There is a myth that is far too widely believed which needs to be challenged.
It goes, “inflation is always good for stocks”.
This feeds into a “no price too high” narrative – famously the four most dangerous words in investing.
The stock market has never been bigger relative to the size of the economy – in the US above all.
Stock market bulls say this time it’s different though, because inflation is good for stocks.
Well, I agree that it’s different this time….
… but what’s different is inflation being good for stocks.
To show this and explain why, I’m delighted to share Charlie Morris’ latest missive to his very lucky subscribers, as a bank holiday special edition.
What inflation does to stock markets
Now that’s a bull market.
Before you write in wondering why I never recommended such a fabulous outcome, consider that you were rewarded in Venezuelan bolivars. Once you take that into account, you’d likely have lost money.
Inflation has been so high in Venezuela that the currency has become unmeasurable outside the black market. There is simply no published exchange rate. I therefore don’t know what the outcome in pounds or dollars would have been, but most likely pretty miserable.
Venezuela is an extreme example, but a worthy one because it reminds us what high inflation does to asset prices. Stocks go straight up in local currency terms provided they survive. When measured in hard currency, they tend to slide, but not collapse.
There are also fewer Venezuelan stocks than there were. There were 61 in 2010, yet just 32 today. From what I gather, only seven stocks are considered to be liquid, which means they can be easily traded.
The list of Venezuelan stocks is shortening, and the liquid survivors are highlighted in the table below. They are in food, agriculture, packaging, chemicals and steel.
The banks have also survived, but not thrived. I presume they hold some US dollars and have privileged access to the inner working of the financial system. That is unlike the miserable population, who have endured tough times. In any event, you can’t buy the banks because they are embargoed securities courtesy of US sanctions.
There are no hotels, airlines, house builders, media, services or leisure. Inflation has destroyed many businesses and taken the market back to basics.
I have no plans to recommend Venezuela, but this list of surviving companies demonstrates how hard assets overcome inflation in a way that other companies can’t. That could be mines or oil, which in this case are state-owned, or industry.
Comparing other markets
I do not know what the price/earnings (P/E) ratio of Venezuela’s stock market is, as no one does.
For an entire stock market, the P/E ratio is a widely used measure of value. It equates to the total capitalisation of all stocks divided by the net earnings/profits of all those companies.
It changes day by day, both due to the fluctuations in the stock market, and to the high inflation in the economy. I imagine that the P/E is low, because that is what we see in other high inflation countries.
Inflation in Turkey inflation is 15%; and in Argentina, 40%. Both countries have stock markets that trade at low P/E ratios. Turkey trades on 5x and Argentina on 6x. Those low valuations reflect the increased risk associated with investing in a country with a record of high inflation and rapid falls in the local currency relative to major currencies such as the US dollar or the euro.
Contrast that with developed stock markets, where inflation is currently low (but rising), and the P/E tends to be much higher. In the US today, the P/E is expected to be 17x in 2023, assuming the anticipated growth is delivered. If those earnings fail to materialise, the P/E ratio will be much higher, unless the stock market falls.
If you plot the S&P 500 Index P/E ratio back to 1950 and show it versus inflation, it becomes clear that the stock market has been cheap (low P/E) when inflation has been high and vice versa.
The experience of the 1970s makes this point abundantly clear. In the early 1970s, the time of the “Nifty Fifty”, the P/E ratio fell from a lofty 19, to 7.
The Nifty Fifty was a group of high growth companies with many great and exciting new ideas. Some companies such as Polaroid, Kodak and Xerox were highly rated, but they didn’t thrive as expected. On the other hand, companies such as Walmart, Coca-Cola and IBM had bright futures.
But whether or not they survived in the long run, the stock market suffered a brutal setback. The valuation didn’t recover until the mid-1980s. And today, it is as high as it has ever been. You can see why I am cautious.
Historic data suggests that P/E ratios would drift towards 15 if inflation rose above 4%. Conversely, the ratio would fall below 10, if inflation rose to 10%.
All of this reminds us that inflation might be great for any government wanting to reduce the real burden of outstanding debts, but truly miserable for investors trying to generate wealth.
With low inflation and a high P/E, the stock market is in the place where it is least likely to deliver a positive surprise. Put another way, there is very ample room for disappointment.
Leaning from Venezuela, hard assets survive. That is companies that own mineral resources or real estate that are prices in hard currencies like the US dollar will be the last to fall.
Venezuelans can also protect themselves by holding foreign assets such as global bonds, gold, and real estate in Miami.
And one day, if there were a regime change in Venezuela, then the sanctions would be lifted, and the economy should begin to recover.
That, in turn, would be an incredible buying opportunity for stock market investors.
The bottom line is: stocks (and stock markets) that are cheap in that they are trading on low P/E ratios have less to lose than those that are trading on high P/E ratios.
Value stocks can go down in price. However, they are less likely to do so because of a compression in their P/E ratios.
Current inflation trends
Why is this relevant? Because inflation is rising. That has been normal during a recovery following a crisis. However, I agree with the widely held view that “this time it’s different”.
With interest rates already at zero, central banks have minimal room to cut further. Official rates and bond yields could turn (or remain) negative, but the appetites of investors and policymakers for this is limited. Instead, governments have decided to stimulate economic activity with large spending programmes and bank guarantee schemes. These programmes and schemes push money straight into the economy.
Other factors such as a shortage of microchips, and a scramble for raw materials, also put upward pressure on prices.
The move away from globalisation is also inflationary. Companies and governments are encouraging use of local suppliers and shorter supply chains – even if this results in slightly higher costs.
The blockage of the Suez Canal by the megaship Ever Given highlights how global supply chains are also vulnerable to disruption by accidents. Such disruption also almost always results in higher costs for someone.
As a measure of inflation, the consumer price index (CPI) is published each month and is a lagging indicator. The forward expectations give a much clearer picture of what really matters to investors. Inflation expectations for the next two years are already at a ten-year high, with longer term expectations following behind, as you can see here.
The big question is whether this inflation passes once the recovery slows down. We simply do not know the answer.
However, sustained higher inflation is something that we need to be prepared for.
I think it’s a superb piece.
You can read more of Charlie’s work here.
All the best,
Editor, UK Uncensored