Inflated Opinions
2022 continues to be unkind to investors. Through June 17th, the S&P 500 is now down about 23%, the Nasdaq 30%, and Bonds are down about 11% measured by the AGG. Recent inflation data further surprised to the upside, with CPI coming in at 8.6%. That led the Fed to increase interest rates more rapidly than previously anticipated as well. Higher inflation puts increasing uncertainty around future profitability - higher inflation historically has reduced valuation ratios, such as the price earnings ratio. Higher interest rates have the same tendency, as future earnings are discounted at a higher rate.
On the positive side, the recent selloff has brought down the highly elevated Shiller PE from around 40x to 29x, although it is still meaningfully above its historic average. My simple 10-year S&P 500 forward return model, which has shown a strong correlation to actual realized 10 returns, has increased from about 1.5% for next 10 years to 4.5%. The model uses 3 straight forward inputs: starting dividend yield, historic growth rates, and mean reversion of valuations, i.e. Shiller PE returns close to 30 year average, etc.
Notable Research
Bridgewater’s Greg Jensen: Interview with Bloomberg TV. https://youtu.be/OedxKLAR6eg
Main takeaways - Fed seemingly has 2 difficult choices, to bring inflation back down to 2%, likely requires much higher rates, 4-5% and for asset prices to decline another 20-30%. Alternatively, the Fed might accept higher sustained inflation, 4’ish% and lower terminal interest rates. Lower interest rates and higher inflation, implies lower real yields.
Seth Klarman: Interview on the Value Investing Channel. https://youtu.be/Kht3dUV6LQE
Gives a broad capital markets overview, Fed and interest rates, economy, valuations, systemic risks.
Jeremy Grantham: Interview on Morningstar’s Long View podcast. https://www.morningstar.com/podcasts/the-long-view/148
Main takeaways - US investors face significant challenges, multiple bubbles bursting, stocks, bonds and real estate. Cash, value, EM, Japan and resource stocks likely best place to hide.
Cliff Asness: AQR co-founder interview on Morningstar’s Long View podcast. https://www.morningstar.com/podcasts/the-long-view/164
Main takeaway - even though value has meaningfully outperformed in 2022, value still looks significantly discounted vs. growth, implying value will likely outperform going forward.
Looking Ahead
Returns are inextricably linked to valuations; that is, the price you pay today and future cash flows realized will determine the returns one ultimately earns. It appears the Fed, for now, has some degree of determination to reduce inflation. The Fed’s tools are powerful but limited - raising rates increases the cost of borrowing, which reduces purchasing power (think mortgage rates, etc.). Raising rates also increases the discount rate, so semi-economic projects are delayed or cancelled, dampening demand. Asset prices also decline when rates increase, further reducing buying power, all of which should help reduce inflation. The Fed, however, can’t increase supply, and it appears that energy, green metals, food, and even labor may be in chronic short supply. I suspect inflation may be stickier than markets anticipate.
Thus, it appears we are likely to see a slow down or recession in the next 12-18 months and elevated inflation. Asset prices, specifically US stocks, still appear richly valued vs. the past. Although the Shiller PE is down to 29x from 40x, recent earnings may be inflated vs. the next decade. The past 10 years do not include a recession. Equally important, profit margins are significantly above long-term average. If you look at the major inputs to profit margins - cost of goods, labor, taxes, interest rates - all seem likely headwinds going forward vs. tailwinds.
Fortunately, foreign value stocks, emerging markets in particular, look quite reasonable if not cheap. The same for Japanese small value stocks according to GMO. Both asset classes may offer typical equity-like returns of 8-10%, perhaps more, while US stocks still look pricey. Finally, natural resource stocks also appear attractive. Resource stocks not only trade at a big discount to the broad market, but it also seems highly likely the demand for critical limited natural resources like Copper, Lithium, Nickel, Palladium etc., will go up substantially.
Ben Clauss, CFA®
Senior Vice President, Investments
Any opinions are those of Ben Clauss and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The information contained in this post does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
