“Don’t touch me; I’m too hot! Y tu lo sabes!” —Usnavi, In the Heights
Ouch! Inflation is heating up enough to burn my fingers. Some quick numbers, and then I’ll try to avoid any more percentages. (Emphasis on “try.”)
The Labor Department reported that inflation in June 2021, as measured by the Consumer Price index (CPI), increased 5.4 percent, year-over-year. That is the highest 12-month rate since August 2008. For context, commodity prices were booming then; oil prices hit a record $150 per barrel.
The so-called “core rate” was up 4.5 percent during that same time. The core rate excludes items that can be volatile in price, like food and energy. But if you ask me, food and energy are pretty core to my daily living. Prices for used vehicles were up a whopping 10.5 percent — not year-over-year, but from May to June! That accounted for about one-third of the rise of the 5.4 percent overall gain.
The good news is that prices are spiking because the U.S. economy is hot, hot, hot! Amped-up demand has resulted from the successful distribution of the COVID-19 vaccines, allowing businesses to ease social gathering restrictions.
The bad news is that it could be even better if it weren’t for the hiring challenges of businesses. The Federal Reserve (Fed) contends, and I agree, that the economy could run even hotter if we could get more of the 9.2 million U.S. job openings filled.
The other bad news is that, although businesses raised nominal wages, inflation-adjusted average hourly earnings fell in May and June 2021. I suspect those comparisons will become more favorable to the worker. Much of that inflation growth is transitory. And given the improvement of sales and earnings, many corporations have seen enough cash flow to increase wages further.
According to the NFIB Small Business Optimism Survey, more than one-fourth (26 percent) plan on increasing wages to increase workers. Nearly half of respondents plan to raise prices to pay for additional employees. That’s the highest rate of expected price increases since 1981. Small businesses are feeling optimistic, thus confident that they can do this and not scare off customers. They’re probably right. It’s a good indicator that the larger companies we invest in will meet their lofty earnings expectations this quarter. Earnings season kicked off last week, and public companies are reporting significant gains in revenue and profits.
The most recent estimate from Refinitiv is for S&P 500 earnings to leap by 65.8 percent for the second quarter of 2021, year-over-year. That would be an increase from 52.8 percent in the first quarter. These massive numbers are, in part, because we were making comparisons to a low base last year. For instance, Q2 2021 growth is only about 8.3 percent when compared to Q2 2019. Don’t get me wrong, that’s well above the 5-year average earnings growth rate of 4.1 percent. But I feel like investors are expecting this outsized growth to be a permanent feature. It’s going to be challenging to justify prices in the stock market as growth rates normalize.
You’re Too Happy
The Conference Board’s Consumer Confidence Index (CCI) tracks how optimistic or pessimistic we are. As you might suspect, it dropped considerably throughout the pandemic. But it didn’t drop as much as it had during other recessions because the government came in swiftly with financial assistance. In June 2021, following gains of the previous four months, the CCI jumped 12 points to 127.3.
Charles Schwab & Co. did me the favor of calculating a lot of data I didn’t want to input into an Excel spreadsheet. They found that we shouldn’t expect much of a return from our equity portfolios over the next twelve months. I’ve often said that I am a contrarian. I prefer to buy stocks when everyone else sells them and sell them when everyone who wants to buy them has done so. As you might suspect, historically, some of the best times to buy stocks have been when consumers are pessimistic. Alternatively, stocks barely grind out returns once consumers are feeling happy. As the Wall Street adage goes, the stock market climbs a wall of worry.
Looking at data from February 28, 1967, to June 30, 2021, Schwab calculated the annualized returns of the S&P 500 when the CCI had been between three ranges. When the CCI was at 68 or below, the S&P 500’s 12-month return was 15.2 percent. When the CCI was between 68 and 106, the S&P 500 returned 8.0 percent. However, when the CCI was above 106, the S&P 500’s annualized gain has been a mere 2.7 percent.
In previous columns, I’ve gone through the same exercise using investor sentiment instead of consumer sentiment. The story was similar. We could further corroborate my concerns by analyzing the Conference Board’s Measure of CEO Confidence, which stands at an all-time high of 82 in the second quarter of 2021.
As a CEO, I desperately want higher CEO confidence levels to correlate with significant stock market gains. But, alas, it’s not so. Analyzing data from June 30, 1976, to June 30, 2021, Schwab found that annualized gains for the S&P 500 were 14.4 percent when the CEO Confidence survey was 55 and below. When the survey was between 55 and 65, the gains were 4.6 percent. When the CEO Confidence survey was above 65, the S&P 500 was practically flat 12 months later, with a gain of 0.4 percent.
Granted, gains of 0.4 and 2.7 percent are still gains, so we shouldn’t be scared out of the stock market on that data alone. But you don’t need to be afraid to be prudent. As a matter of prudence, I’ll be considering two moves in my portfolios. One is some selective pruning. The stock market has been holding up well. For example, the S&P 500 is trading solidly above its 50-day moving average (DMA). (A moving average is a stock indicator used in technical analysis. It smooths out the price average over a specified period.) I have some holdings that are trading below their 50-DMA. I usually give more attention to investments that challenge, or break below, their 200-DMA. But with the stock market at lofty levels and with people just a bit too happy for my liking, I may begin to reduce or eliminate positions I own. The other move I may make is to start building up my hedged positions.
The 12-month returns I just cited aren’t fantastic, but they aren’t worrisome. And I am overall bullish. So, you may be wondering why I am considering making some defensive moves.
The stock market is vulnerable to a Fed misstep. I expect the Fed to start tapering their minimum $120 billion of Treasury and mortgage-backed securities (MBS) purchases they are making each month. The start of Fed tapering, theoretically, leads to a reversal of quantitative easing policies aimed at stimulating and stabilizing the economy.
In the Fed’s most recent Monetary Policy Report, the subheading reads, “The labor market improved substantially in the first half of the year as the economy reopened and activity rebounded.” The Fed had said they would start tapering when they had made “substantial further progress” toward their goals of maximum employment and price stability. I don’t see how the Fed holds off much longer.
That’s not just my opinion. On July 13, 2021, San Francisco Fed President Mary Daly said that tapering could start late this year or early 2022. On the same day, St. Louis Fed President James Bullard said, “the time is right” to begin slowing the pace of bond buying. Not all regional presidents agree. On July 12, 2021, New York Fed President John Williams did say that it’s too soon. But make no mistake, the conversation has started. On July 9, 2021, the Fed released the most recent minutes of the Federal Open Market Committee. The minutes revealed that some participants debated the merits of reducing the purchase of MBS purchases faster than Treasuries “in light of valuation pressures in housing markets.” Still, “several other participants commented that reducing the pace of Treasury and MBS purchases commensurately was preferable because … both provide accommodation through their influence on broader financial conditions.” Let that sink in for a minute. The Fed is buying bonds, which is helping the stock market. The Fed is discussing putting an end to this practice. If the Fed stops doing something that benefits the stock market, what do you think happens to the stock market when they stop?
This article originally appeared in The Berkshire Edge on July 19, 2021.