Inflation & Interest Rate Are Key to Stocks and Markets Going Up/Down

Inflation and interest rates are very important to the economy and asset valuations.

Inflation

Most economists believe that high inflation can destroy the standard of living of most consumers.

Below is the trend for inflation since the late 1950s and also some of the main variables that determine CPI, consumer price index, the index for U.S. inflation.

As the chart shows, shelter is the biggest variable in the inflation equation. Food, energy & gasoline and vehicles are also important components. There many other items in CPI that are not listed on the chart including health care, a major cost for many families and retired individuals.

The calculation, components and the way CPI is reported is very controversial. What is important about CPI, is that it is a benchmark that we can measure overtime, and it does reveal trends in inflation. The chart above does show the long-term trend for inflation.

The high inflation rates of the 1970s were mostly caused by the Arab oil embargo of 1973, 1974 and the Iranian Revolution in the late 1970s.

The other cause of inflation in the 1970s was bad monetary policies. The inflation of the 1970s caused Congress to pass the Humphrey-Hawkins Full Employment Act in 1978 giving the Federal Reserve the responsibility for price stability and to create conditions for full employment.

Most basic economic books explain two type of inflation: 1. Cost pull inflation where the cost of goods rise. We saw this in the 1970s where the spike in oil prices caused cost pull inflation. 2. Demand pull inflation is basically occurs when the economy heats up and too many dollars are chasing too few goods.

In one of the best investment books of the 1990’s, Stocks for the Long Run, Wharton Business School Professor, Jeremy Siegel, explains the rule of 20. The book explains the rule of 19, I round it out to 20.

Overtime the P/E of the market gravitates to 20 minus inflation. If inflation is 5, then the P/E should be 15 (20 minus 5). When I started in this business in 1980 as a stock broker with Merrill Lynch, inflation was 12% and P/Es were in the 6 to 8 range (20 minus 12).

Why do P/Es gravitate towards 20? The P/E is the amount we pay for a dollar of earnings and that includes growth and dividends that are adjusted to inflation. In a perfect world of no inflation, we would pay $20 for $1 of earnings. Investors don’t want to pay for inflated earnings so they subtract inflation. Historically, earnings have grown 7% and investors have been willing to pay 2 times for that growth rate for top American companies. In other words investors are willing to pay $14 for a dollar of earnings for a top company. The average dividend paid historically is 3%. If you add these two numbers you get 17, close to the average historical P/E (14 to 16). The historical average inflation rate is 3%. The average P/E should be 17 (20 minus 3).

During the Great Recession the rule of 20 did not make sense. Investors preferred adjusting the P/E to risk and P/E ratios contracted.

Currently CPI is around 1.8, so the rule of 20 would mean we should have a P/E of around 18. Currently the P/E for the S & P is around 17.8, close to the rule of 20. Every month I do my Monthly Market Outlook and I use the rule of 20, or adjust to P/E to risk, to make a forecast for the markets.

The most effective tool the Federal Reserve has for price stability is raising interest rates. Interest rates are basically the cost of money, and to control inflation you raise the cost of money. They also use open  market operations in the banking system.

Inflation impacts interest rates (investors and savers want to be paid the rate of inflation) and cost of living adjustments.

Interest rates

Interest rates are essentially the price, cost of money. The lower the rates, the more demand, the higher the potential for growth in the economy. The decision to buy or expand if you’re a business or consumer is easier when rates are low.

High rates are detrimental to the economy: it raises the cost to expand, to grow, to buy big ticket items like housing or autos.

Below is the academic equation, definition for interest rates:

1 + r = (1+I) (1+R) where r = nominal interest rate, I = expected inflation, R = expected real rate of return

A simpler definition is interest rates = inflation + time + default risk. The components of this equation are basically the major risks that investors, savers face when they loan their money to the government, banks, corporations, state and local governments ….

Inflation, Investors want to be paid at least the rate of inflation to protect themselves from inflation.

Time, The longer you loan your money out, the more uncertainty and risk there is and investors need to be compensated for time risk.

If you loan your money out for 10-years, you should expect more than loaning your money out for one month.

Default Risk, the safest entity to loan your money to is the U.S. government. It is the only entity that can print money or raises taxes to pay you off: you will be paid.

The opposite may be a new technology company that has an unproven technology, no financial history to base profitability and performance on, an unproven management. Investors should demand a higher interest rate if you were to loan your money to this new company.

Interest Rates and Investments

The main variable of many asset valuations models is interest rates. These asset valuation models include: the discounted cash flow model, capital asset pricing model, dividend discount model, and the earnings yield.

In most of these models, when interest rates are low, assets will be valued higher because assets have more value ( a dollar can go further when inflation is low versus when inflation is high) when interest rates and inflation are low, and because the economy can do better.

When interest rates and inflation are high, cash flows are worth less in the future when discounted to the present. Also when the risk-free rate (treasuries) is high, models tell investors to put money in treasuries because their safer, and riskier assets look less appealing.

Also when interest rates and inflation are moving higher, money leaves financial assets and moves into real assets (gold, real estate) to protect an investor from inflation. The economy also tends to slow, or contract when inflation and interest rates are rising.

When interest rates are high enough, money will leave stocks and move into high interest rate investments, including tax-frees, corporate and government bonds, and short-term money markets. Stocks can’t compete when interest rates get high enough. As mentioned above, the economy tends to slow or contract when interest rates are high.

Interest Rates and the Markets in the 1970s

The 1970s had the oil embargo and an energy crisis causing cost push inflation and rising interest rates. We also had bad monetary policies.

Below is a chart of the Dow 30 and the 10-year Treasury:

Inflation and interest rates essentially went up for most of the 1970s. This was a very difficult time for the markets and stocks.
The market was essentially the same value as it was in 1970 and 1978, 1979.

1980s

In the 1980s, we went from oil supply embargos, disruptions to oil gluts by the mid-1980s. Inflation and interest rates fell, the market took off.

You will notice in all the charts in this report, that when interest rates are rising (blue trendlines), the market (orange trendlines) normally falls. When interest rates are falling, the market normally rises.

Also helping the markets in the 1980s were better monetary policies, and baby boomers were starting families and buying homes.

Rates did start to rise in 1987 because of a strong economy and the 1980 to 1988 Iran/Iraq war caused concerns of oil supply disruptions.

The markets crashed in 1987 for some of the reasons above. The market crash was more of a market event than economic event as the economy continued to grow.
Interest rates fell and the market recovered in the late 1980s

1990s

Most of the 1990s benefitted from mostly low inflation and interest rates, and the digital, technology revolution.

The fed did start raising rates in 1994 to slow the economy.  The market stalled in 1994, but the tech boom started in earnest by 1996.

Post Great Recession

The Fed has kept interest rates lower than normal to stimulate the economy and reflate assets.

Interest rates went to historic lows in 2012 and tested those lows in 2015.

Conclusion

When inflation and interest rates are low, the economy has a better probability to grow, and this should lead to growing earnings. Low interest rates, a growing economy and earnings are ideal for stocks and markets.

When inflation and interest rates are high, the economy can slow or contract leading to lower earnings or losses and falling stock prices and markets.