During extended bull markets, it becomes easy to believe that the path of least resistance is up, and it is more difficult to see the risks that stocks could beat. Take January 2020 when investors remained optimistic even though stock valuations were already seen as stretched. That was just before reports of a virus surfaced in China. That month, the path of least resistance seemed to be open again until Reddit, Robinhood, and GameStop brought the latest example of a black swan memory to the market that there is always something you won’t see coming.
It’s no wonder investors panicked. Sophisticated Wall Street trading instruments, opaque to the investing masses and with the risk of hedge fund failure in the marketplace, are hot spots for past crashes, from long-term capital management to subprime mortgage crises.
There will always be new market risks. Others should be easier to spot, however. Inflation, for example, a classic market bogeyman.
“The arithmetic makes it clear that inflation is a far more devastating tax than anything enacted by our legislators,” Warren Buffett once wrote. “The inflation tax has a fantastic ability to easily consume capital. … If you feel like you can dance in and out of securities in a way that defeats the inflation tax, I want to be your broker – but not your partner.”
Warren Buffett and the worst inflation
Buffett experienced and invested some of the worst inflation rates ever in the 1970s. And before the 2008 crash, he warned that $ 4 gasoline wasn’t a good sign for anyone. But he also warned that the Fed’s pressure on unlimited money would have unintended consequences after the crash. One may have been a bloated stock market, but actual inflation has stayed low, and Buffett recently said that no economics textbook in the last 100 years can explain this market.
Is Game Inflation a classic market sucker who no longer has the power it once had, as GameStop makes investors fear there is a new normal in the market with unknown consequences? It would have been easy to overlook Federal Reserve Chairman Jerome Powell about inflation last week, but he talked about it – and about it at the same time.
“Honestly, we’re welcoming slightly higher, slightly higher inflation. The kind of problematic inflation people like me grew up with seems unlikely in the national and global context we’ve been in for some time,” Powell said after the last FOMC meeting of the Fed.
Although inflation remains low, investors fear that the Fed could unexpectedly reduce its market buying if conditions change, which could lead to another phase of the market turmoil. Even if the GameStop shock goes away, is there a more classic factor that investors need to worry about?
Powell promised that the market would get plenty of guidance before actually tapering off. “When we see that we have reached that point, we will clearly communicate this to the public so that no one is surprised when the time comes,” he said on January 27.
The Fed has been signaling for some time that its policy on interest rates and inflation is part of a new policy that is normal, and it will tolerate higher levels even if employment rises and the economy heats up. The truth is that inflation has been in secular decline for decades, says Nicholas Colas, co-founder of DataTrek Research, and even the entire money printing post-financial crisis didn’t start it. Inflation appears to be holding more power as a politically healthy bite, especially among Republicans, than as market power.
As Colas likes to point out, would you buy it with a visual aid if the chart below was a stock chart?
The Federal Reserve Bank of St. Louis tracks the year-over-year change in headline CPI and is declining.
Federal Reserve Bank of St. Louis
“Most answer ‘no’,” said Colas.
And Colas says it’s hard to imagine inflation rampant in an aging, low-growth population. “The experience in Europe and Japan somehow says no. Population growth in the US has fallen to 0.3%. The average age is rising. And China actually has a worse demographics than the US in this regard. How do we reach global inflation at a slower pace? Household Education and General Pop Growth? “
That doesn’t mean investors should stop worrying. The older and more conservative an investor is, the more this issue can stay in focus as markets return to more traditional worries – not pandemics and trading revolutions based on Reddit.
But Colas says there are a few important things that investors should understand about the new world and inflation. For starters, a bloated stock market doesn’t mean there is financial inflation.
“Many people think that inflation of goods (CPI, PCE) has been replaced by inflation of financial assets.” Colas wrote in a recent research report. “Is that really a thing? Not really. Financial assets are valued using expected future cash flows and discount rates. CPI / PCE measure the prices of things that are consumed (not discounted cash flows). You may think the stock market is overvalued.” But calling inflation is wrong. In fact, inflation can improve future earnings and make stocks more valuable. “
The Fed says expect inflation, but don’t worry
Inflation is coming.
“We’re going to see higher comps soon,” said Colas. “Powell talked about how a revival in consumer spending could drive inflation. In the second half of the year, consumer inflation will be higher. … Powell admitted that.”
In some ways, the inflationary environment resembles the dark days of the 1970s, when Buffett and so many other older generation investors were constantly afraid of their power. Colas noted that during the budget spending of the Great Society era and the Vietnam War, the Fed did not want to pursue policies that appeared to be either contrary to social progress or to a war that can be compared to the current war on the Covid. 19 Virus and government spending on it in the face of mounting economic inequality and concerns about social justice.
The Fed forecasting market does not expect the central bank to be bolder to face this environment anytime soon. The Fed Funds Tracker has a chance of a rate hike by 2022, which is currently between zero and 10%, Colas said.
An initial period of inflation could even be good for stocks and give companies more pricing power and thus better profits. Between the current Fed outlook and the initial impact of inflation on the market, Colas says if GameStop turns out to be a “footnote” – though all bets on it are void right now for those who don’t want to be wrong, what is currently the strongest force on the side Market – then stocks should be able to continue rising.
Watch inflation indicators
There are a few indicators of inflation that investors should consider.
The gold demand is one. Gold fund inflows were negative in the fourth quarter of 2020 after peaking in the second and third quarters of 2020. According to Colas, “If the flow of funds to gold funds goes back to positive, it might mean inflation … but not much is happening now.”
Bitcoin is the “new gold” to watch, but its meteoric surge last year and this year was more a function of institutional buyers buying into the cryptocurrency than fear of inflation, he suspects.
Traditional currency markets can also be observed. Throughout the 1970s, the German and Japanese currencies rebounded each year of the decade. “The yen and Deutsche Mark rebounded until the end. Global marginal investors said inflation in the US was too high and we were not being paid for risk,” said Colas.
The analog is now the Chinese yuan. It is currently in the middle of its 10-year range, but if the yuan were to gain sharply, say 10% to 20%, it would indicate global investors are concerned about the medium-term outlook for US inflation.
The power of the Fed will also be crucial. If the 10-year yield rises, even if “the Fed puts its finger on the scales,” it is a sign of danger.
“Stock valuations are a function of cash flows and interest rates and that’s it. So when interest rates go up, stocks go down unless the earnings growth rate is faster than the risk-free rate,” Colas said.
Some market experts say the current gamestop panic was sparked by Fed policies of too little support for stocks and too little opportunity for savers at low interest rates, while stimulus checks have left more homes bogged down and are unemployed. Americans today act on their future. The current market battle is about a lot more than just that, although it is true that the interest rates on high-yield online savings accounts, which have received a lot of attention in recent years, have fallen. With inflation staying low, the high level of short interest in stocks, which one might say – to use a term often associated with inflation – has increased. The subreddit WSB group (wallstreetbets) has reached 7 million subscribers. With actual inflation next, there are reasons to believe that investors should at least be able to get a better grip on it.