Over the last few months, Inflation seems to have already become the ‘taboo’ word with a negative connotation. I believe many investors have already developed an allergic reaction to terms like ‘Inflation, War, Interest Rates” etc.
This will just be a quick guide to frame your thinking on how you should look at inflation, and it is largely inspired by Professor Damodaran who has the title of being the Dean of Valuation. I will also be appending my notes in the latter part of this post from his 30-minute-long video.
Simply put, the monthly reporting of the inflation numbers is just a stand-alone number. It doesn’t mean anything. Sure, we have headlines talking about “InFlAtIoN HiTs NeW 4O YeArS HiGh” - but what does that mean for us as investors? What does it mean to the stock market - and by extension, what does it mean to the businesses that we own? (Let’s not forget that behind every stock is a real business)
Inflationary effects play out in both top-line (revenues) and bottom-line (profits & margins); some companies benefit more than others in an inflationary environment, and more importantly, the required rate of return on the stocks is affected as well.
Therefore, we need to provide context behind this 8.3%, 8.5%, or whatever the read will be in the upcoming month. We should think of it from the perspective of Expected vs. Actual. This recent 8.3% CPI read, is it based on
a 10% expected, while coming in at 8.3%, or
a 5% expected, while coming in at 8.3%?
There are severe ramifications to which is the scenario. For starters;
If Actual > Expected; Financial Assets are repriced downwards to reflect higher than expected inflation [Change in expectations for the future, pushes down the prices of bonds to reflect the fact that those bonds are less valuable because they give the same coupon rate (in the lower inflation period)] Similarly, the new inflation rate is going to have a severe impact on the upcoming cashflows of businesses and discount rates which would affect the risk premiums involved.
If Actual < Expected; Financial Assets will be repriced upwards to reflect the lower than expected inflation, which essentially suggests the opposite of the above.
Clearly, from what we understand, Inflation numbers came in hotter than expected (8.1%) - and that was probably one of the many reasons that shook the stock market recently. “Blessing in Disguise” - it did come in lower than the previous month, and there seemed to be chatters around this might be the sign of inflation peaking. I would beg to differ, especially when there are too many moving parts in this entire economy game.
Let’s not get excited too early.
Personally, even as we observe that there was an incredible rally right into Friday, I still hold the view that markets remain volatile, and there were no clear indications of drastic moves to change the current trend of markets being confused. Yes, Markets are confused. Presently, market participants are trying their level best to make forward projections of the companies - and whether is X or Y Company a good buy. Furthermore, many have been concerned about the macroeconomic factors that might or might not weigh down on valuations. I think Prof Damodaran provided a very good perspective for consideration. It involves a model after some sort of ‘sensitivity analysis’, laying out the groundwork for thinking.
There are 3 key determinants of value to consider:
State of interest rates - Steady, Massive Increase, Transient
The path of Equity risk premiums - Continue to see a rise, Stay Steady, Drop as inflation sets away
Earnings Estimates - Equals to estimates, fall below 10%, fall below 20%
The above table - which was pulled out from the video, provides a critical perspective on the current market sentiments. It falls straight in line with expecting equity risk premiums to stay at current levels (hopefully), with an expectation for the risk-free rate (Interest rate) to level to a soft-cap of around 2-4%, while earnings estimate to still come in strong, with very low bandwidth for them to miss.
What are your own expectations? For me, I have been sitting on the sidelines for quite some time, other than my previously enacted DCA strategy into indexes (because they’re supposed to follow the system and I shouldn’t intervene just because I hold a particular view, if not it breaks the philosophy of a DCA), and have been disciplined (restricted) in deploying capital. Personally, I sit in the camp where we might slip into a slight recession, earnings might come in around -10% below estimates, and the ERP will continue climbing for some time. Where will it eventually settle to? I don’t know, but probably not at today’s level. I would believe that interest rates would also climb from here (No sh*t Sherlock) - but we will probably not visit the incredible 15% - 20% range in the 70s. I would believe that there would be a soft-cap at 4% - 5% max, for both economical and political reasons.
Happy to hear your thoughts. Subscribe if you haven’t already, and you can catch me on YouTube & Twitter as well.
Love,
Chi Keng
Notes from the Video:
2011-2020 had the lowest and most stable inflation out of all decades from 1950, Variances were also extremely low - Comparable to (1991-2000)
Inflation has gone up and down, but the last decade had an unusually low and stable inflation
Expected vs. Unexpected Inflation > It gets build into financial assets (Securities & bonds)
Corporate/Treasury Bonds - it gets built into the interest rates because you want to get an i/r higher than inflation.
Yield Curve Shift - Rates started rising before the Fed started opening their mouth - Markets are leading the Fed, not the other way around.
Default Spreads have also widened significantly - price of risk has been marching upwards
The Inflation Decade: 1971-1980
Investors had no reason to believe that they were heading into a decade of higher inflation (Sounds Familiar?) - It was OPEC...
Expected inflation lagged actual inflation throughout
Inflation Surprise in 2021 - “Transient in nature” - Covid, Supply Chain, War etc.
Expected Inflation
Consumer Survey (Uni of Michigan) - 5.4% from Consumers, highest value since 1980s
Financial Markets - Difference between 10Y T-bond rate & 10Y TIPs - Measure of expected inflation - Difference is 2.85% (Investor Perspective)
Key Theory behind the difference; Short term vs. Long Term, Consumer over-adjusting (From personal experience of oil & Food prices), Markets are under-adjusting (Market participants resisting to adjust their view)
Rate of Return implied on the stock price
On Jan 2022, US equities priced to earn 5.75% (1.51% Rf + Equity Risk Premium 4.24%)
On May 2022, US equities priced to earn 8.03% (2.89% Rf + Equity Risk Premium 5.14%)
Inflation is to blame for both increase in Rf and ERP - The uncertainty of inflation seems to increase with the level of inflation...
More talks and worries about recession recently
hehehaha inflation can eat one?