January 31, 2022
According to the Consumer Price Index, inflation for the calendar year 2021 was 7%.[1] Some people say that this inflation is “transitory,” but it may very well continue for some time. Faced with inflation how should we invest? Fixed income is almost certainly a loser. The yield on the ten-year Treasury note is about 1.75%, and the yield on the 3-month T-bill is about 0.18%. Even if inflation abates, a yield of 1.75% will not be enough to offset it. If inflation keeps up, interest rates must rise causing bond prices to fall.
What should we think about stocks? We have three thoughts:
Stocks are an excellent investment for the long run.
As long as the earnings yield of the S&P 500 is above the 3-month T-bill yield, stocks will outperform bills and other short duration fixed income. With inflation, longer dated fixed income is out of the question.
While inflation is not good for the economy, stocks can nevertheless hold up during an inflationary period.
STOCKS FOR THE LONG RUN
We cannot know whether stocks will go up or down in the next week or month, but we can be virtually certain they will continue to reach new highs. Just a few weeks ago stocks were at an all-time high. This in spite of the fact that in the past 21 years we experienced the deflation of the tech bubble in 2000–2003 (down 47%), the financial crisis of 2007–2009 (down 55%), and the COVID crash of 2020 (down 34%). To see how well stocks have overcome serious setbacks, consider a concrete example. If we had bought the S&P 500 at a very inopportune time, the end of September 1987, just before the October crash (down 25%), and stayed with it, we would have gained over 3,000% by the end of 2021. That amounts to a 10.6% annual return. If, instead of the S&P 500, we had bought the Growth Fund of America (AGTHX), the total return would have been over 4,800%, or 12.1% per year.
Just a few weeks ago stocks were at an all-time high. This in spite of the fact that in the past 21 years we experienced the deflation of the tech bubble in 2000–2003 (down 47%), the financial crisis of 2007–2009 (down 55%), and the COVID crash of 2020 (down 34%).
STOCKS VS. HIDING OUT IN T-BILLS
It is tempting to think that by switching into T-bills at the right times it would be possible to reduce the volatility and increase the size of our returns. That may be, but it is far easier said than done. We did a study in which we showed that you can benefit by switching from stocks to bills and back from time to time. A strategy that worked very well was to switch to T-bills whenever the yield on T-bills exceeded the earnings yield on the S&P 500 by 1.6% and to switch back when the earnings yield exceeded the T-bill yield by 1.1%. (Earnings yield is the reciprocal of the price/earnings ratio; that is, E/P, rather than P/E.) There were only nine switches during the 63-year period studied. Currently, the earnings yield of the S&P 500 is over 4%, while the yield on the 3-month T-bill is under 0.2%. Now is not a good time to switch.
The earnings yield of the stocks in our clients’ portfolios is even higher than that of the S&P 500. For the Equity Select portfolio it is over 9%; for the Dividend portfolio it is over 5.5%; and for the Mutual Fund portfolio it is just over 5%.
The earnings yield of the stocks in our clients’ portfolios is even higher than that of the S&P 500.
STOCKS VS. INFLATION
Inflation is not necessarily good for stocks, but stocks can still perform well in a period of high inflation. We looked at the last period of very high inflation, from the end of 1972 to the end of 1981. During that period inflation averaged 9.2% per year. The S&P 500 did not keep up, but it did gain 5.2% per year. A well-managed portfolio, however, did considerably better than the S&P 500. The Growth Fund of America (AGTHX), which was started on December 1, 1973, returned 14.3% per year from its inception until the end of December 1981. The S&P 500 returned 8.2% per year for the same period. Inflation averaged 9.3%.
We looked at the last period of very high inflation, from the end of 1972 to the end of 1981. During that period inflation averaged 9.2% per year. The S&P 500 did not keep up, but it did gain 5.2% per year. A well-managed portfolio, however, did considerably better than the S&P 500.
OUR OUTLOOK
The S&P 500 has risen at a rate of nearly 15% a year for the past 10 years. Many people worry that because it has risen so fast it is on the verge of a major decline. We agree that some of the stocks that have led the market higher are now vulnerable. In 2021 five stocks accounted for about a third of the S&P 500’s gain. According to Bloomberg, all five have P/Es above 28. One, Tesla, has a P/E of 177. The others are Microsoft with a P/E of 34.7, Alphabet (Google) 29.7, Apple 28.7, and Nvidia 66.7. A big part of the reason these stocks sport such high P/Es is that interest rates are extremely low. Because bonds yield practically nothing while still representing risk, investors have preferred stocks to bonds. As a result, stock prices and P/Es have gone up. The earnings yields of the companies just mentioned range from 0.56% (Tesla) to 3.5% (Apple). With low inflation and the 3-month Treasury bill at 0.18%, these may be acceptable levels, but as inflation and interest rates rise, they won’t look very good.
With rising interest rates stocks that have low P/Es, good dividends, and solid balance sheets should hold up much better than those that have high P/Es. To get an idea of what could happen, take a look at the bursting of the tech bubble. From March 24, 2000, to October 9, 2002, the S&P lost 47.4% of its value (with dividends reinvested in the index). For the same period, three mutual funds with more of a value orientation did much better. The Victory Sycamore Established Value fund (VETAX) lost 14.1%, the Lord Abbett Mid Cap Stock fund (LAVLX) gained 20.2%, and the T Rowe Price Capital Appreciation fund (PRWCX) gained 24.2%.
With rising interest rates stocks that have low P/Es, good dividends, and solid balance sheets should hold up much better than those that have high P/Es. Three well managed mutual funds performed better than the S&P 500 during the tech bubble burst.
We don’t think the current situation is as extreme as in the year 2000, but we think there is some similarity. At that time tech companies had risen to prices that could not be justified by any foreseeable earnings. Today the tech companies that have been leading the market higher do have earnings, but even accounting for projected growth, their prices are hard to justify. There is no law to say the prices of overpriced stocks can’t go higher. If they do, lower priced stocks should also do well. If the high-priced stocks go down, stocks with earnings yields well above the 3-month T-bill rate should hold up much better or even go higher.
[1] CPI for urban consumers, not seasonally adjusted went from 260.474 on December 31, 2020, to 278.802 on December 31, 2021.