Stocks continued to rise last week. While leading NASDAQ names tried to get some footing after recent declines, the Dow names continued to surge ahead. In the race of value versus growth, value has been the steady winner since Labor Day, reversing a decade of relative underperformance. While futures point to relative calm this morning, I should note that, as Shakespeare says, “Beware, beware the Ides of March”. Today is March 15.
The S&P 500 is now taking aim at the 4000 level. At the moment, it is a little more than 1% away. To many that might sound like irrational exuberance. Looking at some of the SPACs, GameStop, and Bitcoin, it isn’t hard to feel that way, but none of these wildly speculative names are in the S&P 500. They sit out on the fringes where the only rational reason to buy shares at current levels is an expectation that someone, for whatever reason, will be willing to pay you even more when you decide to sell. Most of these speculative targets have little or no revenue, and certainly no earnings. Yes, one or two may become the next Amazon# or Tesla, that is the dream supporters are chasing. But most will fade to oblivion over time.
However, there is a real market out there and we shouldn’t lose focus on that. With the Fed still pumping over $5 billion daily into markets, and Congress passing multi trillion-dollar bills with only the thought of raising offsetting revenue, there is plenty of fuel for higher prices. Moreover, the same fuel is powering a record setting economic recovery. Nominal GDP growth in 2021 could approach 10%, double what was formerly considered normal. 2%+ productivity growth, combined with modest population expansion and 2% inflation, gets you to around 5% as a normalized growth rate. But only the Fed priming and government spending gets us to a 10% possibility.
As political pledges become enacted into law, earnings expectations rise. Right now, we believe annualized S&P 500 earnings will be close to $200 per share by the fourth quarter of 2021. By the end of 2022, they could be $225 per share, or even a bit higher. If those numbers are either correct or even too low, then stocks now sell at less that 20 times forward earnings and close to 17.5x annualized Q4 2022 results. Set against a backdrop of 10-year Treasury yields still well below normal, it becomes clear that the core S&P market isn’t irrationally valued. I am not saying it is cheap. Rather I suggest that it is very rationally valued. Its future direction will be determined by the future courses of earnings expectations and interest rates.
As the economy recovers, we learn a lot. First, we find corporate America is rather resourceful. Well run companies have recovered faster than expected while controlling the pandemic damage. Second, while overall capacity utilization remains below normal, aggressive inventory management, combined with a faster than expected recovery, has led to shortages of many items. While shortages mean lost sales, they also mean greater pricing power for the suppliers. These shortages are not likely to be long lasting. Most, if not all, will get resolved within months. But tight supply is better for overall earnings growth than slack demand. Third, Fed stimulus and massive Federal spending are powerful growth forces in combination. Fed stimulus, by itself, merely sets the table. Low interest rates aren’t impactful if no one borrows. But higher demand induces more borrowing and greater economic activity. Congress has now passed over $4 trillion of stimulus over the past year and it is talking about a $2 trillion infrastructure bill ahead.
The flip side of all this is more inflation and higher rates, not good for stock prices. Intuitively, a surge in economic activity should bring a surge in inflation. Obviously, the rise in 10-year yields from 0.9% at year end to about 1.6% today is a reaction to that, even though core inflation numbers to date show very little change. What we have seen is a spike in commodity and home prices. Both are impacted by short supply. In the commodity world, higher prices will bring out more supply quickly. In the U.S. alone, with oil over $60 per barrel, one can expect drilling activity to add 1-2 million barrels per day over the next year. Add in another 1-2 million from Russia and Saudi Arabia, especially if prices rise further. The housing expansion has led to a surge in lumber prices. Given that there is no shortage of trees, the culprit is tight sawmill capacity. That will be alleviated within months. Even in housing, higher prices will bring more homes to market for sale. That may take more time, but eventually supply and demand will rebalance. For every new home sold in America there are 3-4 resales. While new home prices are rising, it is the resale market that sets pricing for the industry.
With all the upward pressures on prices, it would seem that accelerating inflation is inevitable. But here are several opposing forces to consider.
1. Technology is, by far, the biggest suppressant to rising prices. Technology reduces the cost of production in many obvious ways. It also enhances price discovery. The buyer can search the Internet to find the best value. That has been the case for years. But it is still a dominating anti-inflation factor.
2. Globalization is next in importance. While President Trump steered the nation in the direction of a more nationalist path, in manufacturing, the world is still global. Maybe over time more semiconductors will be made here, but not today.
3. For 1-2 generations, workers have gotten used to low single digit annual pay increases. Breaking that trend will take years. Even if wage growth rises toward 4% annualized, productivity gains of 2% or more will neutralize the inflationary impact of higher wages. Wages are the single greatest component of costs.
4. Deflation has become prevalent in some economic sectors. Leading drug companies, for instance, now are seeing net realized drug prices decline year-over-year. For years, health care costs rose significantly faster than the rate of inflation. Higher education was another sector that experienced costs rising far greater than average. But with the college experience impacted by the pandemic, and enrollments down, now is likely not the time to accelerate tuition increases. Instead, greater use of virtual learning will drive down costs and allow schools to be more competitive
5. There remains plenty of excess capacity. Too much office and retail space, for instance. There isn’t a clothing shortage, either.
On balance, therefore, the fears of accelerating inflation may be a bit overblown. Time will tell. As noted many times, this year will be a collision between rising earnings and rising interest rates. A couple of weeks ago, as rates surged, the market buckled a bit. Now, with rates a bit more stable, economic optimism is winning. With rates still low, stocks should continue to move higher in the first half of this year. But as rates rise, the forces of continued acceleration may lead to more volatility in the second half of the year. It is too early to determine the final outcome. But for most stocks, valuations today are rational. It is only at the speculative fringes that we experience craziness. That will get corrected over time. Whether GameStop goes to $2000 or $20 over the short term is anyone’s guess. Long term it will get a lot closer to $20 than $2000. In between, if you are a buyer, here’s hoping that someone, for whatever reason, will be willing to pay you more.
Not that long ago, the Black Eyed Peas were the hottest rock group around. Its lead singer, will.i.am, turns 46 today. If you were a Desperate Housewives fan, Eva Longoria is also 46 today.
James M. Meyer, CFA 610-260-2220