Why Inflation Typically Damages Stocks
DECEMBER 31, 2021
At some point, we plan to expand our emerging market presence utilizing our new emerging market investment vehicle, Gibson Mountain LLC. The advantage of this special purpose vehicle is that your account need not be registered with every country in the world. There is no additional charge associated with our using Gibson Mountain.
… If the market began to fear strong and continuing inflation, it would damage stocks for three reasons. First, corporate profits are very sensitive to wage rates, and wage rates are sensitive to inflation. Rising wages could easily halve corporate profits. Corporate profits are also reduced by any increase in borrowing costs. In addition, aging bubble markets are vulnerable to even small dips in corporate profits.
Second, an increase in rates could affect the discount applied to future corporate earnings for valuation purposes. This is a very complicated subject which we will address in some future letter or on our website. Third, if inflation is not transitory, it could trigger even more severe Fed rate hikes….
The primary role of the Fed these days is as a buyer of last resort for bonds required to finance swollen federal deficits. These bonds are required because under current law it is illegal for the Fed directly to buy government debt. Given this limitation, the bonds are sold to Wall St. dealers who then sell them to the Fed….What the Fed wants is 1) successful placement of all U.S. government bonds and 2) modest inflation that gradually reduces the real (inflation adjusted) federal debt burden….
Treasury Secretary and former Fed chair Janet Yellen has recommended that the Fed in future buy stocks directly with its newly printed money in order to put a floor under stock prices. The Bank of Japan and of Switzerland already do this, although the latter does it to control its currency, not its stock prices.
It is presently illegal under U.S. law for the Fed to buy stocks but that could [easily] change. During the Covid Crash, the Fed said it would buy junk bonds. That step was also of dubious legality….
The key for commodities is the limited supply that exists following years of under-investment.
We deliberately avoided Chinese stocks completely prior to their fall. We also owned no Russian stocks….
By the end of the year, the price/dividend ratio of the S&P 500 was 77X versus an historical norm of 27. The price/dividend ratio is rarely cited, but dividends are the one part of corporate results that cannot be manipulated. A taxable investor would of course need more than 77 years to earn back the purchase price via dividends. In addition, at the end of the year, 15% of S&P 500 stocks sold for more than 10X sales. At the top of the 2000 dot com/ tech bubble, it had been 6.5%. This percent began climbing above 6.5% in 2019….
From the beginning of April 2021, 51% of S&P 500 gains came from only five stocks. Ned Davis Research, a widely used service, lists an “elite eight:” Apple, Amazon, Facebook/Meta, Google/Alphabet, Microsoft, Netflix, Tesla, and Nvidia. The NASDAQ gain for 2021 was 23%; removing the top five stocks reduced this to about 5%. By year end 2021, Teladoc, a remote healthcare provider, was down 70% from its high, but was still trading at 14x sales.