Death of stocks: does inflation kill the stock market?

This monetary morning … inflation and stocks …why raising rates can be detrimental to stocks … is there anything to do? … and much more …

August 13, 1979 BusinessWeek on the cover was the infamous headline: “The Death of Stocks: How Inflation Destroys the Stock Market.”

Three years after the publication, the stock market went to the crater … before going on a steady run.

Since its low in 1982, the S&P 500’s total return on reinvested dividends has reached almost 7,000%.

In a Bloomberg retrospective, the cover jokingly says: “Not bad for a corpse.‘

Is that infamous story on the cover relevant today?

In the US, the Nasdaq fell more than 13% in April, the worst since October 2008.

Since the beginning of the year, the index has fallen by about 21%. the worst start of the year.

The broad S&P 500 index fell for four consecutive weeks, falling 8.8% in April and bringing losses from the beginning of the year to 13%.

And the Dow Jones Industrial Average fell more than 9% in 2022. The S&P 500 and Dow Jones indexes recorded the worst months since March 2020.

All this time, global inflation is reaching a level unnoticed for decades.

Reduced average inflation in Australia, for example, rose 1.4% in the last quarter, the highest since ABS began calculating the figure in 2002.

Rapid inflation is boosting bond yields in line with the central bank’s hawkish response expectations.

Yields on the 10-year U.S. Treasury eventually rose to 2.88% in late April, the biggest monthly increase since December 2009.

In just one night, yields finally reached 3% for the first time in more than three years.

The 10-year-old counterpart of Australia fluctuated at 3.26%.

The American Individual Investors Association poll reached its bearish mark since March 2009, and this week JPMorgan strategists wrote that “investor sentiment is reaching extreme weakness. ‘

So…

Is this a harbinger of the death of stocks? Or the bell of death will ring with malice as well BusinessWeek story?

Inflation and stocks

This 1979 cover based its final diagnosis on stock returns, which are no longer ahead of inflation.

As noted in the article:

‘Stocks were a reasonable hedge when inflation was low. But they have proved helpless against the terrible inflation of the past [1970s] decade.

‘“People no longer think of stocks as inflation hedging, and from experience, that’s a reasonable conclusion they’ve come to,” says Richard Cohn, an associate professor of finance at the University of Illinois.

‘Indeed, since 1968, according to a Salomon study by Salomon Bros., stocks have risen by a disappointing annual rate of 3.1%, while the consumer price index has risen 6.5%.‘

Although not as fatalistic as in 1979 BusinessWeek Historically, many market players today are pessimistic about stocks in the near future.

Terribly, some even repeat BusinessWeek‘s point about the meager real return on stocks against inflation.

In a research note this week, Morgan Stanley stock strategist Mike Wilson wrote (emphasis added):

‘The real profitability of the S&P 500 is the most negative since the 1950s.

‘With such high inflation and a rapid slowdown in income growth, stocks no longer provide the inflation hedging that many investors expect.‘

And Peter Castello, chairman of the Australian sovereign wealth fund Future Fund, said:

‘As we’ve been saying for some time, investors should expect lower returns than in the past, in the long run.‘

Supporting his colleague, Future Fund CEO Rafael Arndt noted:

‘Looking ahead, we expect profits to be harder to achieve due to persistent instability and disruption in global markets and the economy coupled with rising inflation that will remain as key themes for some time to come.‘

Why raising rates can be detrimental to stocks

But the fact that inflation eats real profits is not the only concern.

Inflation to treat himself poses problems.

In Australia, the bond market is betting on a series of increases, which will bring the cash rate to 2.5% by the end of the year.

Pretty a twist after years of stable low rates.

But rising interest rates increase bond yields, which affects the valuation of stocks.

First, bond yields set a minimum price for corporate borrowing costs. Higher yields lead to higher debt costs.

And the higher the cost of debt – bad news for stock growth, and profitability – a distant marker.

As one fund manager said Australian Financial Review this week:

‘If it takes time to fully implement an idea, as it usually does, “the problem with a very significant balance is that time is not your friend.”‘

The Wall Street Journal repeated this point yesterday (emphasis added):

‘Shares of companies whose biggest earnings are far in the future also suffer because higher Treasury yields reduce the attractiveness of long-term future earnings expectations.

‘Some businesses that analysts fall into this category, such as plant food maker Beyond Meat and space tourism firm Virgin Galactic, have suffered from bruises in the markets this year, falling 43% and 44% respectively.‘

Take the local BNPL industry, whose past highs and current lows embody the full cycle of the Wheel of Fortune.

The industry is struggling to turn growing transactions into profits by supporting itself with equity and debt.

But the tin is rattling hollow as stock prices plummet. For example, Zip fell 85% in 12 months.

Thus, BNPL shares are forced to use debt markets for financing. But rising rates will only worsen the cost at a time when margins are already small.

Just this week, for example, Splitit reported a net transaction margin of 1.6%. Honestly, the SPT said the sector is facing severe headwinds.

‘The escalation of write-offs in installments for buyers and rising costs of buying sellers calls into question the path to profitability for BNPL suppliers.‘

Rising interest rates will only add extra potholes on BNPL’s endless path to profitability.

Is there anything to do?

Some think we have entered a fruitless period for investment.

Morgan Stanley stock strategist Mike Wilson believes stocks have “moved into a phase where virtually no strategy works, even defensive action.‘

True to their name, opposites disagree.

If Mike Wilson of the market plays, the opponents are prone to death.

Contrarian Foundation manager Ann Christine Farstad told Australian Financial Review a profile this week on how her foundation struggled with COVID’s turbulence in 2020:

‘We need despair and fear, and COVID was interesting because it was a crisis of epic proportions.‘

Similarly, when COVID first devastated markets in March 2020, high expected inflation coincided with periods of heightened risk aversion and economic uncertainty.

But does it provide opportunities … or traps? How do you feel about the current environment?

For Farstad, a probabilistic relationship is enough. This is gratitude for the sustainability of excellent enterprises.

‘The fact is, Farstad admits, that to be the successful opposite, you don’t need to be right about the future.

‘With a probabilistic approach, she only needed to conclude that “everything will be fine in these companies, regardless of whether the recovery will take place next year, in a year or in a year.”

‘In fact, she doesn’t understand how growing investors can pay multiples of the top market ratios for businesses where a certain margin of safety is so small.

‘“I don’t know how growth guys do it; I don’t know how they say: “I will pay 30 times more for it, because I am absolutely sure that this company is the winner at the end of the road.” I can’t do that. “‘

The trick is to have a portfolio of great, strong businesses that can use the good times and are sustainable in the bad.

Sincerely,

Kirill Prokopenko,
For Morning money