Inflation's Low. That's Not Enough To Justify Expensive Stock Markets

By James Mackintosh Features Dow Jones Newswires

Hollywood isn't likely to make "Federal Reserve: The Movie" any time soon, and not just because Janet Yellen goes out of her way not to say anything meaningful if at all possible. The problem for the scriptwriters would be the absence of a villain for Ms. Yellen to fight, now that inflation seems to have all but disappeared.

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The film could be livened up with shots of rich investors partying like it Is 1999, and they wouldn't be hard to find. Economists and central bankers might be frustrated by the failure of their models to predict such low inflation for so long, but investors are delighted by what they see as ideal conditions for stocks.

I have been skeptical of the market's confidence that inflation will stay low as unemployment drops. But another question looms large for investors: even if inflation has been conquered, does that justify high stock prices?

The question might seem dumb. Low inflation means low interest rates and so higher prices for equities. As projected future profits are worth more in today's money, companies spend less to service their debts and shares become more attractive relative to low-yielding cash and bonds. What isn't to like?

History confirms the simple view, in that stock valuations have on average been much higher when inflation is below 4% than when it is above. Even better, the S&P 500 on average rose about 8% in the year following inflation coming in below 4%, against just 2% gains for faster inflation.

Unfortunately, averages conceal a lot, and in this case they hide the truth. The truth is that what matters most to stock prices isn't where inflation stands, but where it will stand in future compared with what is currently priced in. Investors like low and stable inflation, but some of the best times to buy stocks have been when inflation is very high, and about to plummet, as in 1979. Equally, some of the worst times to buy stocks have been when inflation seems under control, but is about to take off, as for example at the end of 1936.

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Even worse, the average hides massive variation. Data put together by Yale Prof Robert Shiller for the S&P and U.S. inflation back to 1871 show that investing when inflation was between 1% and 2%, as it currently is, offered a 1-year gain in the S&P averaging 8.6% -- with dividends on top. Not bad, you might think as you dial your broker. But the range was huge, from a whopping rise of 41% to a loss of 35% -- again depending on whether inflation subsequently rose or fell.

This might seem like ancient history, but in August 2007, considered by many to be the start of the financial crisis, inflation was below 2% and the stock market was booming.

Perhaps most relevant is late 1965. Inflation had been below 2% for seven years, stocks were on a roll and Beatlemania was at its height in America. Investors seemed to agree with John Lennon as he sang "I Feel Fine," and stock valuations hit their highest since 1929 on the widely used Shiller P/E ratio, which smooths the cycle by comparing price to 10 years of earnings. It would be another 30 years before U.S. shares were again so highly valued.

Few trading today were even born in the 1960s, but Dan Fuss was trading bonds at the time. Now vice chairman at Loomis, Sayles & Co in Boston, he sees similarities with the 1964-66 period, when inflation was quiescent.

"The Fed chose to soak the field in gasoline so when the match came it would be a problem," he said of the 1960s. Just as then, he thinks the Fed is restrained by domestic politics from tightening policy, making it hard for policy makers to respond when inflation does start to pick up, and he is worried it is on its way.

The consensus is that inflation is going nowhere fast. U.S. consumer prices rose 1.9%, slightly more than forecast, in the past year, data on Thursday showed, giving heart to those betting on another Fed rate increase this year. Yet, almost all the increase came from surging prices of gas and shelter; strip out energy, food and shelter and inflation is close to the lowest ever.

The risk is that investors are once again being lulled into a false sense of security. The calm of the 1960s was broken in 1967, when core inflation -- taking out volatile energy and food prices -- jumped more than 2 percentage points in just 12 months, and highly-valued stocks proved vulnerable. If the bad guy turns out to be lurking just off screen, Hollywood's scriptwriters may yet have a plot worth watching.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

September 14, 2017 14:19 ET (18:19 GMT)