Inflation is the stock market’s worst nemesis which lurks on the horizon.
My recent article pointed out that after adjusting for inflation, it took 30 years (or until 1959) for the stock market to recover to its 1929 high. The revelation prompted me to conduct additional empirical research on GDP and its components from 1929 to 1942. My goal was to use empirical data to assess the potential risk for an increase in inflation from the 2020 global economic collapse. Inflation is a market’s worst enemy since it results in a contraction of the PE multiple, a stock’s key valuation metric.
A Bit Of History
During the period of 1929 to 1937, the culprit which caused the 20-fold increase in inflation, at its peak, was the significant decline in capital spending. The chart below depicts that capital spending as a percentage of total GDP went from 11.6% of GDP in 1929 to 1.6% in 1932. For all but three of the years from 1930 to 1942, capital spending as a percentage of GDP lagged 1929.
The subpar capital spending from 1930 to 1942 resulted in a decline of output or manufacturing capacity. However, the recovery of the economy (depicted in the chart below) along with population growth of 7.3% from 1930 to 1940 resulted in consumption reaching a new all-time high in 1936. The paradox was the demand for goods and services outstripping the supply during an excessively high unemployment environment.
The chart below depicts a June 2019 forecast for a decline in global capital spending for 2020 and 2021. Due to the unforeseeable event of the Coronavirus wreaking havoc on the world economy since the June 2019 forecast, the decline in global capital spending will likely be much greater and will last for years, as was the case for 1929 to 1942.
The unavoidable result from the rate of inflation increasing significantly will be following.
- An increase in interest rates: The US Federal Reserve and the rest of the world’s central banks would have to raise their discount rates to ensure that inflation does not get out of control. Therefore, the Federal Reserve could go from the stock market’s best friend to its worst enemy. The increase in interest rates would be devasting for the prices of all long-term government and corporate bonds. Interest rate increases would also be devastating for the prices of residential and commercial real estate since mortgage rates would also increase.
- A contraction for PE multiples: The math that a market utilizes to determine the assignment of a PE multiple is earnings growth minus inflation. For example, if a consumer goods manufacturer is growing at 10% and inflation is 5%; the net growth for the company is measured at 5%. In a zero-inflation environment, the standardized multiple for a 10% earnings growth rate equates to 10. For the same 10% growth under a 5% inflation scenario, the PE multiple is discounted by 50% and would be 5 instead of 10.
Inflation Vs P/E
The chart below depicts the extreme polar opposites for PE multiples and inflation through 1949. Inflation steadily increased to highs of 5.1% in 1937, 13.2% in 1942 and 19.7% in 1947. The PE multiples steadily declined as the inflation increased.
An increase in the inflation rate is perhaps the most important of all risks for an investor to consider. Another consideration is that the SCPA algorithm has forecasted that the US market as well as the dozen other countries experiencing market crashes in 2020 to decline by 79% to 89% from their 2020 highs. This will happen when they reach their bottoms in the fourth quarter of 2022. The table below depicts three of the SCPA’s March 2020 forecasts which were extraordinarily accurate.
Michael Markowski has been involved in the Capital Markets since 1977. He spent the first 15 years of his career in the Financial Services Industry as a Stockbroker, Portfolio Manager, Venture Capitalist, Investment Banker and Analyst. Since 1996 Markowski has been involved in the Financial Information Industry and has produced research, information and products that have been used by investors to increase their performance and reduce their risk. Read more at BullsNBears.com