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Why an Inflation-Driven Selloff Might Be a Good Thing

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Shopping in a Walmart store in Hallandale Beach, Fla.

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Inflation could cause the stock market to fall hard, but there’s no need to panic. Such a pullback would likely mean investors are merely adjusting their valuations on stocks–not that something is horribly wrong with the economy.

The specter of inflation has recently reappeared. Consumer inflation has risen higher than estimates, causing the

S&P 500

to fall 4% from its all-time high hit on May 7 to its lowest daily close of the recent selloff on May 12. Investors are concerned that inflation could prompt the Federal Reserve to lift bond yields sooner rather than later. Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable.

The average trailing price/earnings multiple on the S&P 500 can hit 30 times during periods when the consumer-price index rises between 0% and 2% year over year, according to Rosenberg Research data, making stocks a more attractive investment. But the P/E multiple trends downward as inflation goes up, hitting below 10 times when inflation is above 10%.

Some observers are now wondering how high inflation can go. Economists expect CPI inflation to be 2.7% for all of 2021, according to FactSet. But with much of the trillions of fiscal stimulus dollars still not yet spent, that estimate could be conservative. “The likely sustainable inflation rate, after we get through the noise of the next several months, is 3% to 3.5% percent,” argues
Doug Ramsey,
chief investment officer of the Leuthold Group.

That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices. That, coupled with easy year-over-year comparisons to the lockdowns of 2020, has brought recent consumer inflation readings to above 4%. But even if inflation settles at a lower rate, it could still be pretty hot.

If Ramsey is right, equity valuations are likely to fall considerably. The trailing P/E multiple on the S&P 500 that corresponds with a 3% inflation rate is in the ballpark of 18 times, according to Rosenberg Research. That’s far lower than the current multiple of 27.1, according to FactSet. Aggregate earnings per share on the S&P 500 are running at $195 for 2021, based on first-quarter results. If the index ends the year trading at a P/E of 18, it could fall a bit more than 15% from its current level.

It’s possible that “we’re going to go into next year around 18 to 19 times [trailing] earnings,” says Leuthold Group Chief Investment Strategist
Jim Paulsen,
who adds that the S&P 500 could fall to 3,500, a 16.5% drop, at some point this year.

None of this means the economy is faltering or that the market will fall into an abyss, just that investors will need to reassess how to price stocks before the rally can continue. The economy–and earnings–are expected to keep growing beyond this year. Economists expect gross-domestic-product growth in 2022 and 2023 of 4% and 2.3%, respectively, according to FactSet, and analysts are looking for EPS in the S&P 500 to grow just over 11% in 2022 and 9% in 2023.

This means that, when the market finds the right valuation level, stocks can resume their move upward. Inflation “doesn’t mean it’s the end of the current bull market,” says Michael Sheldon, chief investment officer at RDM Financial Group. “While we could very well see a correction as we head into the summer, we remain constructive as better economic growth lies ahead.”

Don’t panic if stocks have an ugly correction in the near future. It could well be an ideal buying opportunity.

Write to Jacob Sonenshine at [email protected]

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