Come on Down: Markets Look to See if the Price Is Right
Prices for seemingly everything have been on the rise, from consumer goods to commodities to houses to stocks. Last week's release of the latest Consumer Price Index (CPI) report showed that inflation may be simmering from a boil. Meanwhile, the stock market has paused to catch its breath as well. Does this signal a new direction for prices? Here's our take:
Source: Bloomberg, Edward Jones. Oil price change excludes temporary 2020 drop into negative territory. Treasury yield measured by % change in the yield of 10-year U.S. Treasury bonds. The S&P 500 index is unmanaged and cannot be invested in directly.
This chart shows the drastic jump in prices following the 2020 market low of oil and lumber, followed by a sizeable drop since their peaks.
Consumer prices: inflation is dropping back, but not immediately and not all the way
- Last week's release of the latest CPI report showed that inflation moderated again in August, which we'd attribute in part to the passing of the base effects (moving past the year-over-year comparisons to the depths of the crisis) as well as some progress in supply-demand mismatches.
- Core inflation, while still quite high, eased to 4% last month, down from 4.5% in June. This is a welcome sign for the markets, as it's consistent with the Fed's stance that the surge in consumer prices will be transitory, allowing monetary-policy settings to remain accommodative.
- Underlying trends in the August inflation data offer a mixed take on the state of the economy. Used-auto prices (a key contributor to recent inflation pressures) declined versus the prior month, an indication that supply shortages are beginning to clear. Away-from-home food services rose at half the pace of the prior two months, perhaps reflecting some progress in labor shortages. At the same time, rather sharp declines in hotel room rates (-2.9%), airfares (-9.1%) and car-rental prices (-8.5%) compared with July is a clear indication of the impact the delta variant is having on consumer demand and activity within the travel, leisure and hospitality sector.
- In our view, the latest CPI report signals that peak inflation pressures are subsiding, but they're not disappearing. Our base-case expectation remains that inflation will recede but settle in at higher levels than we experienced over the last cycle. Moreover, labor shortages and supply bottlenecks will begin to clear, in our view, but more gradually than desired. Last week's University of Michigan Consumer Confidence survey showed a slight improvement from the previous reading, but also revealed a deterioration in reported buying conditions for housing, autos and durable goods, suggesting that high prices are likely to have a dampening effect on big-ticket purchases.
- Peaking inflation rates should take some pressure off of the Fed, allowing monetary stimulus to be withdrawn at a gradual pace, starting with our expectation for reduced bond purchases starting later this year. Looking at prior economic cycles since 1990, as inflation rates peaked in the recovery, the following year saw solid stock-market gains along with modest moves in interest rates.
|Following 12 Months|
|Early-Recovery Peak in Core CPI||Change in Core Inflation||Change in S&P 500||Change in 10-yr Treasury Rate|
Source: Bloomberg. S&P 500 Price return. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly and are not meant to depict an actual investment.
This chart shows the rapid climb in inflationary levels in 2021, but the most recent reports showing signs that inflation is receding from its peak.
Housing prices: From red hot to warm; broader outlook is favorable
- U.S. housing prices have risen by nearly 20% over the past year as demand has outstripped supply. The pandemic has spurred new buying trends and preferences (suburban migration, remote work space, etc.) which, coupled with the robust economic rebound and broadly healthy consumer financial conditions, indicate that the housing market should enjoy ongoing support. The household debt-service ratio (debt costs as a percentage of disposable income) stands close to record lows near 8%, indicating that consumers have sufficient credit capacity to support ongoing home purchases.
- We think supply will begin to catch up, helping soften skyrocketing home-price increases. Housing starts are up 13% in 2021 versus 2020, with more room to rise to meet the surge in demand. Higher home values and increased construction have lifted housing inventory recently, but the number of homes listed for sale is currently 46% below the average level over the last 20 years.
- The surge in lumber prices has been a contributing factor in rising home prices. The price of lumber has fallen more than 60% from the highs this spring, signaling that some relief in housing costs is on the way.
- Though we don't anticipate the pace of recent home-price appreciation to be sustained, overall we think there is a positive circular effect that will continue to play out with the housing market. The ongoing economic expansion, falling unemployment, and healthy household financial positions should support ongoing demand, construction activity and home values. In turn, healthy sales activity and higher home values should support overall consumer-spending growth, contributing to the ongoing economic expansion.
Source: Bloomberg, past performance is not a guarantee of future results, the S&P 500 is an unmanaged index and cannot be invested in directly
The graph shows that the S&P 500 has not experience a 5% or more pullback in almost a year, which is on track to match the longest stretch in the first 18 months of a new bull market going back to 1966.
Stock prices: a choppier road higher
- While the rise in consumer prices is less than desirable, there are few complaints about the rise in stock prices. The S&P 500 has risen 35% over the last 12 months, though some fatigue may be setting in with stocks pulling back last week, leaving them flat over the past month. This may feel disappointing given the market's run this year, but it shouldn't be cause for larger concern. During the last bull market (2009-2020), there were several phases in which equities treaded water. In our view, periodic pauses are normal, if not necessary to prevent a buildup in euphoria.
- In the last three decades, there have been two years (1995, 2017) in which the market didn't experience even a 5% pullback1. With the largest drawdown this year is currently at 4%, it's not out of the question that 2021 could join that list. However, we suspect the remainder of this year will bring more volatility and temporary weakness than we've experienced so far in the past eight months. Since 1991, there have been 13 years in which the market did not see a 10% correction. The average gain in the following calendar year was 10.4%, indicating that periods of moderate volatility and drawdowns don't foretell a coming downturn.
- The price investors are paying for stocks relative to corporate earnings is elevated as well, but also coming down. Based on Bloomberg consensus earnings estimates for the next four quarters, the current price-to-earnings ratio for the S&P 500 is 21.4. While this is notably above the longer-term average of 16.5, we'd note that there are two factors offering support to valuation levels:
- Strong expected earnings growth. Corporate profits rose by 92% year-over-year in the second quarter and are expected to grow by 22% for the full year of 20211. Despite this year's sharp rebound, earnings are estimated to grow by another 9% in 20221.
- Low interest rates. While we expect longer-term interest rates to rise gradually as inflation remains sticky and the economic expansion regains some momentum, rates remain near historical lows. And with the Fed unlikely to raise its policy rate for at least another year, a low-interest-rate environment is supportive of above-average equity-market valuations.
- We think the combination of a sustained economic expansion, accommodative monetary policy, and solid earnings growth will provide the fuel for the bull market to continue. However, we think the market is vulnerable to some near-term setbacks as these conditions shift.
- GDP growth has the potential to be underwhelming in the third quarter as the resurgent pandemic curbs consumer activity.
- The coming Fed taper will begin to reduce the liquidity cushion that has softened equity-market pullbacks. Monetary policy remains a tailwind, but short-term dips may be more pronounced than the scant 2%-3% pullbacks investors have endured over the last 12 months.
- The bar of expectations for earnings growth, while broadly favorable, may be more difficult to hurdle as the pace of economic growth temporarily moderates. Any downward revisions to upcoming earnings expectations could provide a spark for equity-market anxiety. We think any such episodes would be short lived, but investors should anticipate greater swings as we advance.
Source: Bloomberg, forward 12-month consensus earnings estimates. Past results are not a guarantee of future returns. The S&P 500 is an unmanaged account and cannot be invested in directly.
This chart shows S&P 500 earnings against forward PE ratio multiples.
Craig Fehr, CFA
Source: 1. Bloomberg
Weekly market stats
|Dow Jones Industrial Average||34,585||-0.1%||13.0%|
|S&P 500 Index||4,433||-0.6%||18.0%|
|MSCI EAFE *||2,348.46||-1.4%||9.4%|
|10-yr Treasury Yield||1.37%||0.0%||0.4%|
Source: Factset, 09/17/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Morningstar 09/19/2021.
The Week Ahead
Important economic data being released this week include Housing Starts, PMI composite, and the Fed Funds Target upper bound.
Craig Fehr is a principal and the leader of investment strategy for Edward Jones. Craig is responsible for analyzing and interpreting economic trends and market conditions, along with constructing investment strategies and and asset allocation guidance designed to help investors reach their financial goals.
He has been featured in Barron’s, The Wall Street Journal, the Financial Times, SmartMoney magazine, MarketWatch, the Financial Post, Yahoo! Finance, Bloomberg News, Reuters, CNBC and Investment Executive TV.
Craig holds a master's degree in finance from Harvard University, an MBA with an emphasis in economics from Saint Louis University and a graduate certificate in economics from Harvard.
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