Stocks fell sharply once again. This time, however, the villain wasn’t Omicron or anything to do with Covid-19. This time it was Congressional testimony before the Senate by Federal Reserve Chairman Jerome Powell, warning of persistent inflation and possible slower growth.
In the 1970’s there was a word to describe persistent inflation and no real growth. The word was stagflation. Stagflation meant just what it said. All growth was eaten up by inflation. Real growth was zero, or close to it.
Back in the 1970s, inflation was double digits at its peak. We are only at half that rate today. Moreover, as supply chain kinks are unwound, it would be logical that at least some of that inflation we see today would unwind. Within a year, oil prices more than doubled. Food prices spiked. The inability to import sufficient goods through California ports led to further price increases. A lack of truckers increased freight rates. A lack of new housing units over the past decade sent home prices skyrocketing and rents higher. With semiconductor chips in short supply crimping the supply of new cars, rising used car prices alone sent the CPI up almost two full percentage points. In some cases, used cars sold for more than the comparable new cars which weren’t available! That clearly won’t continue.
That is not to say inflation will suddenly fade away. As we note often, wages will continue to rise at a faster pace than over the past decade. Rents will stay high until the housing shortage is alleviated through sustained increases in new homes. But inflation isn’t going to disappear. For months, the Fed has labeled inflationary pressures as transient. Yesterday, Fed Chair Powell said inflation will remain elevated at least through mid-2022, and the word transient is no longer appropriate. That alone slammed the Dow by close to 500 points, or close to 1.5%. To top it off, Treasury Secretary Janet Yellen reminded Congress that the debt limit will be reached within weeks unless Congress extends it. Congress has been in recess until this week and clearly hasn’t given raising the debt limit the urgency it deserves. Republicans offer the Democrats little help. Yes, debts today relate to past spending, but the debt ceiling increase will be tied to future spending, and Democrats want to spend a lot.
While all this is happening, the economy at the moment is doing fine. In fact, it is doing better than fine. Consumers are spending. Businesses are expanding. The economy is fine. But some of the impetus is going away. During the peak of the pandemic, Congress was handing out checks right and left to offset the pandemic’s impact. It paid unemployed Americans $15 per hour to stay home. It still gives checks to families for simply having children at home. All this while less than 50% of Americans pay Federal income taxes. And the Build Back America plan wants to pay out more if passed.
Thus, there is logic to yesterday’s decline.
But wait a minute. Markets often tend to exaggerate, in both directions. Given the sharp advance over the past year, any correction, even of moderate size, could be a realistic possibility. A year from now, we will still have inflation, but it is unlikely to be 6% or more unless demand surges from current levels. As Washington handouts are cut (e.g., extended unemployment benefits have expired) and savings rates fall, that seems highly unlikely. High prices alone will crimp demand growth. And, of course, Covid-19 isn’t disappearing. Delta and Omicron won’t be the last waves. The pandemic will end sometime fairly soon, but Covid will be as visible as the flu for several years. If you accept that vaccinations help, there will be boosters for at least the next few years. If there is any good news, the fact that so many wear masks and remain socially distanced in public probably means that the odds of a severe cold and flu season are less than 50-50 this year.
It should also be noted that large parts of the market were in decline before the name Omicron was created. The story stocks with little fundamental support were declining. Many are now in free fall. Maybe the poster child of this should be Robin Hood, the trading platform that popped up suddenly to support the speculative euphoria of younger Americans to not only participate in the market, but to become rich overnight. Many didn’t just buy speculative favorites like GameStop or AMC, many bought on margin or used call options to leverage their bets. For a while, they all worked. More were attracted. Then only some worked. Today, none are working. These “weak” hands are trying to salvage what they have. Their selling only exaggerates the decline.
None of this obviates the fact that many stocks were overpriced before the recent market slide. Just as an example, one of the hot stock market concepts of late was the transformation of a cash economy to a digital economy. Most likely, all of us carry a lot less cash today. Simply tap your debit or credit card and you complete a transaction. Venmo, Zelle or CashApp move cash from you to a friend in seconds. Stocks related to instant digital payments skyrocketed. Now names like Square, PayPal# and MasterCard are in retreat. They aren’t doing poorly, they are simply destined to grow at lower rates in the future. In any environment, selling at 50-100x earnings isn’t sustainable.
When you witness markets like this, there is no separating the wheat from the chaff, and markets treat all the same. Some of the selling will be overdone, just as some of the buying on the upside was overdone as well. This is what corrections are all about, cleansing the excesses. In the process, some bargains are created. Disney# now sells at a market capitalization $20-30 billion higher than it was before Disney entered the streaming world. For a while, investors loved the opportunity. Last quarter, one when Disney had few new offerings, Disney’s subscriber growth disappointed investors. Given there was little change to the long-term outlook of the rest of Disney, investors effectively cut the value of Disney+ by two-thirds. Was that valid or was it an overreaction? Time will tell.
The obvious question is whether the current correction is complete. The obvious answer is no one knows for sure. Powell and Yellen have a second chance in today’s House testimony to temper yesterday’s comments, or at least offer a different, more soothing spin. In an emotional market, no one can time the end of a correction, but there are several signs to suggest this one won’t be extended much longer.
1. Earnings continue to grow.
2. Long-term interest rates, the primary determinant of P/E ratios, have declined. That suggests P/Es should be higher, not lower.
3. Volatility indices haven’t broken out to the upside. Fear is growing, but there are few signs (yet) of hysteria.
4. There are no signs yet that Omicron is going to result in a massive increase in hospitalizations and deaths. Very preliminary evidence says it isn’t more severe than prior variants. To the extent that current vaccine formulations don’t work as well as desired, future versions will be modified to be more effective. Simply said, with proper precautions and without lockdowns, we will be able to live with Omicron at least as well as we lived with Delta.
In short, this decline is less about Covid-19 and its variants, and more about fears that the Fed will take the wrong steps. In the immediate future, the concern will be the pace of tapering. That means the extent of the tailwind could fade faster. Headwinds don’t start until the Fed decides to raise interest rates. When that happens, the pace of increases is subject to future economic developments, meaning future inflation and future growth rates. Markets like to speculate, but right now that is somewhat fruitless. Even if one accepts that inflation and growth both will slow, it’s the ultimate rates of inflation and growth that matter. No one knows yet. Is the Fed “behind the curve”? Maybe. But a faster tapering and a couple of rate increases will enable it to catch up. On the other hand, maybe inflation will fade, and the Fed could raise rates slowly.
I have noted several times previously that I don’t believe 20-21x forward earnings is sustainable longer term. Simple reversion to the mean suggests that earnings over the next 1-2 years will be solid, but sustained inflation means P/Es will be lower. That suggests a choppy market ahead. One or two P/E points in either direction will determine whether 2022 is an up year again or not. But if it isn’t, it isn’t a disaster. Long-term investors know it isn’t a one-way street.
Times like now shake the trees. The weak fall to the ground. Corrections could be 5%, 10% or more, but corrections when rates are falling and earnings are rising rarely are substantial.
Today, Bette Midler is 76.
James M. Meyer, CFA 610-260-2220