Stocks Love Inflation

Major stock market indexes opened mixed this morning (Dow +8 points; SPX -.1%; Nasdaq -.3%). Retailers, banks and aerospace are faring well in early trading. Technology and materials are losing altitude. The VIX fear gauge continues to languish below 17. Commodities are broadly lower, with gold down .3%, copper off .6% and oil down .8%. The bond market is selling off across the board today as interest rate expectations rise. The 10-year Treasury Note yield ticked up to 1.61%.

Wharton Professor Jeremy Siegel, typically seen as a stock market bull, was interviewed on CNBC Friday. He said that despite all-time highs, “I don’t see general market over-pricing,” noting that “stocks love inflation until the Fed gets serious about it. And they have not been serious about it.” He reminds us that at the height of the dotcom bubble in 2000, technology stocks were trading at 60-70 times earnings and risk-free 10-year Treasury bonds offered 5-6% yields. Today, conditions are very different. The stock market is trading at 20 times earnings and bonds don’t offer competitive yields. Thus, many investors don’t see bonds as a credible alternative to stock investments. But while stock valuations are not unreasonable, the market will surely experience “tremors” if the Fed pulls forward rate hikes—that is, if they speed up the process of removing monetary stimulus.

My sense is that the Fed is acutely aware of this and doesn’t want to be responsible for derailing the economy. But if the economy remains strong, certainly rate hikes are around the corner. The Fed’s basic plan is to begin incrementally raising its short-term policy rate around mid-year 2022. That rate is currently set to a range of zero to .25%. According to Bloomberg News, at least two Fed officials—Bill Dudley and Jeff Lacker—expect it to eclipse 3% by the time this economic cycle hits its peak. The two conditions required for higher rates, inflation sustainable at or above 2%, and full employment, seem to have been met.

Morgan Stanley’s chief US equity strategist just apologized to clients for his rather bearish 2021 stock market prediction. Mike Wilson is usually fairly accurate in his projections, but says he was wrong about two key variables: corporate earnings and the stock market’s price-earnings (PE) ratio. In other words, he underestimated Corporate America’s ability to grow sales and profits, and also how much investors would be willing to pay for stocks. He’s been concerned that a growth slow-down will show up just as the Fed begins removing stimulus. So he’s sticking with a conservative outlook, predicting a 6% decline for the S&P 500 over the next 12 months.