Could the S&P 500 Fall -50% in 2022?
In the past inflation has had a decimating effect upon stock values.
Summary – the following opinions are backed up by the data below
Current valuations are at generational highs.
Money printing by the Federal Reserve and the U.S. Government could cause inflation to rise significantly.
Inflation has a reputation for ‘destroying stocks’, a common phrase you can hear on Wall Street.
If inflation rises to the 8% to 10% range it is possible for the S&P 500 to fall to around 2600.
Historical Highs – Bubble Valuations
According to many, the U.S. stock market is trading at extremely high valuations as measured by numerous valuation metrics. One of the broadest measures of stock market valuation is the ‘equity market cap to GDP’ metric; Warren Buffett’s favorite coincidently. Simply, some investors gauge the value of the stock market compared to the economy (value of all stocks divided by GDP, as determined by the sources listed at the bottom of the graph below).
Between 1870 and 1996 the stock market has typically been 50% of the value of GDP. The dot.com bubble pushed the ratio up to a ratio of 150%. The money printing by the Federal Reserve Bank and the US Government, after the 2008 Credit Bubble, has pushed the ratio up to about 200%. This is roughly four times the historical average.
Record Money Printing and Inflows into the Stock Market
M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money. M2 is a broader measure of the money supply than M1, which just includes cash and checking deposits. M2 is closely watched as an indicator of money supply and future inflation, and as a target of central bank monetary policy.
The government has printed a massive amount of money. Excess money printing can create high inflation levels. The two charts below illustrate the point.
The government has printed 35% of the total amount of money that has ever been printed, in the last two years (M2 has risen to $21T from about $15.5T). In my opinion this is inflationary.
It appears to me that a large portion of the additional $5.5T printed by the government, through last July, made its’ way into the stock market which in my opinion has helped to push stock valuations to record highs. This chart makes the point, the inflows into equities since 2006 are 3x the record.
High Inflation Can be Detrimental to Stock Market Returns
Stock valuations have an inverse relationship with inflation (inflation is defined as the change in the Consumer Price Index year over year). The higher the inflation rate the lower the valuation for stocks and vice versa. During time periods of low interest rates and inflation, the past ten years is an example, stock valuations can trade to high levels (the upper end of what is possible) – when this happens investors sometimes refer to stocks being in a bubble.
The following chart illustrates the point. The data source for inflation is the Consumer Price Index and the data set for the price earnings ratio is the Dow Jones Industrial Average. As inflation increases (X-axis) the Price Earnings Ratio (P/E Ratio on the Y-axis) goes down. Effectively what investors pay for a dollar of earnings is reduced, which in effect reduces stock prices.
Let’s apply this 121 year relationship between inflation and valuation to the S&P 500 to see what the future might look like if inflation causes a problem for investors.
On December 31st, 2021 the S&P 500 closing price was 4766.18 (source: Yahoo Finance historical data). Total S&P 500 earnings ended the year at $206.38 (source: New York University Stern School of Business). On January 1st, 2022 the S&P 500 PE Ratio reached 26.08 (source www.finakso.com).
Quite simply, using the scatter plot above, with a CPI at 10% we could assume that S&P 500 earnings could be priced using a multiple of about 13. With a CPI at 8% S&P 500 earnings could be priced using a multiple of 15. The most recent CPI reading was 7.0% (source U.S. Bureau of Labor Statistics, December 2020 to December 2021). The following chart uses these figures, outlining possible future values for the S&P 500 Index (the Potential S&P 500 Value is calculated by multiplying the P/E Ratio for any given level of inflation by S&P 500 earnings per share (EPS):
Caution is Warranted
Investors should be aware that the Federal Reserve might need to raise interest rates dramatically to combat inflation. As a result investors may significantly change their valuation levels for U.S. equities, resulting in a potential drop for the stock market.
If inflation increases and/or continues to stay in the high single digits it is possible for the S&P 500 to trade between 2682.94 and 3714.84 (using the aforementioned example). This would mean the level of the S&P 500 could be reduced by -43.72% to -22%.05%, from its’ 12/31/2021 level of 4766.18. Caution is warranted.
Note: past performance is not an indication of future results and expectations might not materialize. Current investor concerns could evaporate as fast as they occurred.
LPL 1-05271991
DEFINITIONS
Consumer Price Index - The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
Dow Jones Industrial Average - The Dow Jones Industrial Average (DJIA) is an index that tracks 30 largest, publicly owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The DJIA is named after Charles Dow, who created it in 1896, and his business partner, Edward Jones.
EPS – Earnings per share (EPS) is a figure describing a public company’s profit per outstanding share of stock, calculated on a quarterly or annual basis. EPS is arrived at by taking a company’s quarterly or annual net income and dividing by the number of its shares of stock outstanding.
FRED: Federal Reserve Economic Data – a database maintained by the Research division of the Federal Reserve Bank of St. Louis that has more than 500,000 economic time series from 87 sources. The data can be viewed in graphical and text form or downloaded for import to a database or spreadsheet and viewed on mobile devices. They cover banking, business/fiscal, consumer price indexes, employment and population, exchange rates, gross domestic product, interest rates, monetary aggregates, producer price indexes, reserves and monetary base, U.S. trade and international transactions, and U.S. financial data. The time series are compiled by the Federal Reserve and many are collected from government agencies such as the U.S. Census and the Bureau of Labor Statistics.
Highcroft Wealth Shield –Highcroft Investments Advisor’s Wealth Shield program is a discipline that has capital preservation as its’ primary objective. Using a rules-based discipline the program exits investments that have broken into a bear trend, shifting those investments into alternatives that are in a bull trend or into a defensive position (cash and U.S. Government bonds). The discipline helps to limit losses or lock in gains, helping to prevent precipitous declines, and can result in a clients’ account holding 100% cash at certain points. We believe that investment management should comprise a plan for growth of assets as well as preservation of assets. Wealth Shield acts as a brake when investments and markets generate downward momentum. The rules-based system is designed to help preserve capital and help avoid investments that are in a bear trend.
Highcroft Wealth Shield Availability - The Highcroft Wealth Shield program is only available in Strategic Asset Management (SAM) accounts managed on a full discretion basis in the Highcroft Investment Advisors, the program is not applied to other SAM accounts or to any brokerage or 401k accounts.
Price-to-Earnings Ratio - The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
S&P 500 Index - The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90. The index is a capitalization weighted index of the 500 large companies listed on various stock exchanges (such as the NYSE or NASDAQ). The S&P 500 was developed and continues to be maintained by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global. The S&P 500 differs from the Dow Jones Industrial Average and the NASDAQ Composite index, because of its diverse constituency and weighting methodology. It is one of the most followed equity indices, and many consider it one of the best representations of the U.S. stock market.
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