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“Expect nothing and you will never be disappointed.”
― Unknown
We have received many questions asking for further clarification on the topic of inflation expectations following our commentary yesterday.
Everyone seemingly wants to know why the new inflation expectations are so bearish for the stock market.
You see, regular people can feel inflation everywhere, and yet are confused about how this specifically impacts Wall Street and equity valuations.
Let’s start by understanding that “inflation” has been felt differently by Wall Street than it has been by consumers, and that this difference is key to understanding what “inflation expectations” are, who sets these expectations, and why they are so important to the future of valuations.
Let’s start with the average Joe Consumer. He is feeling inflation’s heavy hand in every facet of his life.
Today, our dollars buy him less gas…
Buy him less food…
Buy him less housing…
Buy him less…
Everything.
Which is why inflation is the #1 news story on the weekend political shows. Inflation is among the top search terms on Google, and it’s the number one headwind facing the Biden administration.
When prices in goods and services rise at this pace, it punishes the average consumer.
But inflation has been a completely different reality for Wall Street. What may surprise many readers is that while inflation has affected most of us, the paper markets have not been affected at all over the past year.
Not at all, in any negative way, shape, or form.
In fact, paper markets have experienced deflation as it relates to the strength of the US dollar, which has actually gotten stronger against a basket of other major currencies in the last 12 months.
On January 7th, 2021, the US Dollar Index (DXY) stood at 89.32.
Today, the DXY opened at 96.20. This is an increase of 7.7% in the dollar’s value against other major currencies over the course of one year.
Wall Street has benefited from this deflation. As we will see, equity valuations can thrive on a currency that is getting stronger, especially when it occurs while interest rates remain at 0%.
You see, the “lack of inflation” for Wall Street has meant soaring asset prices.
But this is not new. This has been the case for the last four decades. Don’t forget the Fed Funds Rate in 1980 was 20%. Today it’s 0%. This equates to a 41-year downward trajectory in interest rates over time, which has allowed Wall Street to enjoy a golden age.
When the average person thinks of inflation over forty years, they think about the price of a home or a car in 1980. They are not thinking about the direction of inflation expectations over that time.
As interest rates have continued lower and lower over time, expectations about inflation have trended lower for over forty years.
Bonds are up 400% during the last four decades. Stocks are up 1200% in the same period.
But inflation expectations have been incredibly low since the housing collapse. The Fed Funds rate has been stuck at 0% for most of the last 14 years.
Wall Street is all about future expectations. We don’t invest in stocks for what they are doing today, but rather how they will grow in the future.
A simplified hypothetical example that strips out many variables will help us to understand.
Let’s say that my future predictions about the ABC Widget Company are that they will grow their earnings and profits in the coming years. For simplicity, let’s say I am willing to pay a 10 times multiple on their earnings of $1 billion today to participate in that growth. Let's say we expect future profits to be $10 billion dollars five years from now and we expect zero inflation during that time.
If we are correct about our inflation expectations and the company meets our targets, a 10X multiple may be the perfect valuation.
But, if the company meets all of our projections and we are wrong about inflation, then the math can become better or worse.
In a deflationary environment where interest rates continue to fall over time, a company's current cash flows become more valuable tomorrow. The opposite is true as well. If inflation rises over time, then today’s share prices may be overvalued.
This valuation process is called a “discounted cash flow” model. If future earnings have to be discounted more today because of inflation, then today's valuations are too high and must be repriced lower.
Consider a dollar that’s worth 25% more in five years than it is today. In this scenario, the 10X multiple on the stock is low, because in 5 years the company’s $10 billion could actually be worth $12.5 billion and could warrant a 12.5X multiple.
In this deflationary world, in our hypothetical simplified example, today’s multiple is arguably 25% undervalued.
Now, let’s figure a dollar that’s worth 25% less 5 years from now due to inflation. $10 billion in 5 years from now in that scenario, would really only be worth $7.5 billion in tomorrow’s dollars and could mean a 7.5x multiple.
If we are wrong about our inflation expectations, we could be overvaluing the stock by 25% today.
And that’s the whole ballgame.
We have seen extreme valuations in stocks in large part because future cash flows have not been discounted too aggressively because nobody has been expecting any inflation on the horizon. It’s one major reason why equity valuations are the highest in history.
Now that we understand why inflation expectations matter so much to today’s stock prices, let’s talk about who sets these expectations.
The Federal Reserve set these expectations.
Over the past year, we’ve heard at nearly every Fed FOMC meeting that inflation is “transitory,” with Powell saying it wouldn’t last and therefore didn’t exist.
The Fed has argued that rising costs were the result of “supply chain issues” caused by the pandemic, and have set expectations for the market that inflation was not here to stay, and we would be back in a disinflationary environment before long.
Stocks have soared because traders and investors have believed the Federal Reserve.
But this week it became clear that the Fed changed their mind on inflation. Now the Fed is “resetting” expectations that inflation is here and may be here to stay for a long time. Instead of 0% rates for 2022 they promised a year ago, they are now saying they will raise rates up to four times in the next twelve months.
Think about the absurdity of this.
The entity that controls the expectations also controls the stock valuations. If the Fed says inflation is not coming, stocks can soar. But if the Fed says otherwise, investors must rethink how they invest.
This is why stocks are witnessing dramatic volatility in the last few days. The Fed has changed its tune.
We will see what the Fed actually does soon enough. The next meeting is on January 25th and 26th. Expect significant volatility as we head into that meeting.
Will the Fed follow through with their new tough-guy talk? This is the big question.
While Wall Street has actively front-run the Federal Reserve over the last year as they promised inflation isn’t real, it now must reprice what those future expectations represent against today’s value it now seems they either lied or were just flat out wrong.
If the Fed follows through, we could see stocks collapse as investors are forced to reset their inflation expectations. If the Fed continues to follow through with four rate hikes as they are now saying, we believe we will see a minimum 25% drawdown in the Nasdaq, which has benefited the most from inflation expectations being so low for so long.
All of which highlights The Great Devaluation.
We believe that four decades of deflation on Wall Street will now be followed by a significant period where the inflation curve rises higher and higher over time.
We believe the Federal Reserve will intentionally stay behind this inflation curve, and as they do growth stocks with giant multiples based on disinflation could dramatically sink in value as they become repriced. As this occurs we expect the unloved value stocks and value plays of the last decade will make more and more sense to investors.
I will personally lay out this thesis in a free live presentation on January 18th and explain why the vise grip between inflation and deflation is getting tighter and tighter.
The presentation is called Thinner and Thinner Ice.
You can sign up for that free presentation here.
As a parting thought, consider one last thing.
The Federal Reserve is now talking about aggressively reducing their balance sheet while at the same time adding assets to that balance sheet.
This is the monetary equivalent of a dog chasing its own tail.
The question I leave you with today is this: “is this a dog that we should be following? Or is this a dog-headed nowhere fast?”
The market is chasing its tail today, but smart investors need to be chasing value.
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