Inflation Rears Its Head

Inflations Rears Its Head. The stock market just finished a volatile week. Certainly, it was not as volatile as the end of January 2021, June 2020, or even mid-March 2020 when the CBOE VIX spiked to over 80 and COVID-19 seemed to bring the world to a halt. Still, there is a let of news and talk in social media about inflation. Stock prices are more volatile and stock prices of go-go tech stocks and valuation metrics have dropped, but not enough to make them inexpensive. Most everyone’s favorite electric vehicle stock, Tesla (TSLA), is down -23.5% in the past month and is trading at ~$675 per share after establishing a high of ~$900 per share earlier this year. Other tech stocks and broader stock market indices are down too. Certainly investing in stocks is humbling, one month you are up and a few weeks later you are down. The bubble is not popped but it seems to be deflating. What gives?

Inflation Rears Its Head

Stocks and Inflation

Stocks are down because inflation leads to rising costs for many companies and consumers. Both the price of goods and services rise. Businesses have to spend more for their inputs as the prices of commodities, electricity, natural gas, and so on rise. Inflation can lead to higher salaries and labor costs for companies that in turn slows hiring. Consumers, like you and me, can buy less for the same dollar. Consequently, revenue and margins are adversely affected and profits decline…at least in the short-term until businesses adjust.  

In theory companies should be able to raise prices at the same rate as inflation. If the cost of beef goes up 3% then McDonald’s should be able to raise the price of its burgers by 3%. But there is a caveat, if a company faces intense competition not every company will behave rationally. Some companies will absorb the cost of inflation accepting lower margins. Other companies may even operate at a loss at least for a short time expecting inflation pressures to ease. This will limit the ability to raise prices.

Is Inflation Really Rearing Its Head?

How do I know that inflation is rearing its head? On a personal basis, I went grocery shopping this past week and the cost of milk, half-half, eggs, beef, pork, and chicken were up from the week before. The organic milk that my kids drink is now $4.29 compared to $3.99 last week, a 7.5% increase. The big box of waffles that my kids like went up to $6.39 from $5.99. The price of organic eggs went up too. The price of gas is up from a year ago as well. You get the idea; the costs of basic necessities are rising.

From an investor’s perspective, the breakeven inflation rate is heading up after plummeting during COVID-19. The breakeven inflation rate represents a measure of expected inflation derived from the 10-year and 5-year U.S. Treasuries, respectively. The breakeven inflation rate was expected to rise but the values for both the 10-year and 5-year breakeven inflation rate are higher than before the pandemic and also higher than the U.S. Federal Reserve’s target of 2%.

Source: Federal Reserve Bank of St. Louis

Is this a problem? Maybe not if it is short-term. Fed chairman Powell doesn’t think that the surge in inflation will be sustained. Increasing vaccine distribution should put the U.S. and global economy back on track reducing supply chain disruptions. The yield curve is steepening after being inverted and flat during much of 2020 indicating that bond investors are expecting economic growth. Furthermore, unemployment and underemployment are still relatively high and business bankruptcy rates are rising keeping a lid on demand. But what if he is wrong?

Shortages, Trade Wars, and Massive Stimulus

There is a combination of shortages and massive stimulus that is in my opinion is causing inflation to rear its head. In the U.S, cold weather affected much of the mid-west, great plains, and south-central U.S. Texas and other areas of the south saw cold weather they had not seen in about two or three decades. Power, water, and natural gas supplies were disrupted in Texas and other States. This affected farms and businesses on top of disruptions caused by COVID-19 slowing processing, transport, and killed livestock. Some of these disruptions are starting to show up in the form of higher prices. 

In reality though inflation of basic necessities is a global phenomenon where the problem is of greater magnitude, especially since food costs make up a greater percentage of income compared to the U.S. 

However, it is not just basic necessities that are being impacted. The trade war, which is still occurring in the background of the COVID-19 pandemic, has raised prices on imports of many items. The most glaring example is that we are now faced with a global semiconductor shortage. Lead times are about one year now. The consequence is real as automakers, electronic manufacturers, and medical device companies are now being affected. Most global automakers are slowing or cutting production. Tesla is temporarily halting its Model 3 line in California for two weeks due to chip shortages. There are other contributing factors such as fires in some critical plants, stockpiling of semiconductors by companies due to the U.S. – China trade war, and lower global air freight volumes but higher prices resulting from COVID-19.

Lastly, the U.S. and other major economies have pumped about $9 trillion of stimulus into the global economy. The U.S. is now its third stimulus bill of $1.9 trillion. You can argue about the merits of another stimulus but much of this stimulus is debt financed and it is increasing the money supply that in turn is driving the stock market higher. Classic economic says that large amounts of money creation by central banks and high fiscal deficits should cause inflation.

Final Thoughts on Inflation Rears Its Head

So, that about summarizes my thoughts on why inflation is rearing its head. Yes, there is likely to be volatility in the stock market as investors recalibrate expectations for revenue and profit growth. However, stocks are thought of as more of an inflation hedge than fixed income investments, which subjects you to the risks of inflation, over longer periods of time. I am personally staying invested.

Chart or Table of the Week

I like to take a look at my watch lists periodically to see where to add new money. One thing I am noticing is that consumer staples companies are not doing well in 2021 compared to 2020. One company I want to highlight is Colgate-Palmolive (CL) [Disclosure: Long CL]. Colgate is down -10.7% placing it in correction territory. The forward P/E ratio is 22.8X based on consensus 2021 earnings per share. This sounds high but it is lower than the trailing 5-year average of 24.6X. The forward yield is 2.3%, which matches the 5-year average. The stock has not yielded more than ~2.8% in the past decade.

The company has raised the dividend for 58 consecutive year making it a Dividend King. The payout ratio is about 56%. This is a defensive stock with a low beta of 0.68 and low max drawdowns. The screenshot below is from Stock Rover* and shows some risk characteristics for Colgate compared to its industry and the S&P 500. Clearly, it offers some downside protection.

Source: Stock Rover*

Dividend Increases and Reinstatements

Allstate (ALL) hiked the dividend 50% to $0.81 from $0.54 per share quarterly. The forward yield is 3.1%. This is the 11^th consecutive annual increase. Allstate is a Dividend Contender.

Home Depot (HD) raised the dividend 10% to $1.65 from $1.50 per share quarterly. The forward yield is 2.4%. This is the 12^th straight yearly increase. Home Depot is a Dividend Contender.

Perrigo Company plc (PRG) increased the dividend 6.7% to $0.24 from $0.23 per share quarterly. The forward yield is 2.3%. This is the 17^th yearly increase in a row. Perrigo is a Dividend Contender.

Waste Management (WM) hiked the dividend 5.5% to $0.575 from $0.545 per share quarterly. The forward yield is 2.1%. This is the 18^th consecutive annual increase. Waste Management is a Dividend Contender.

Silgan Holdings (SLGN) raised the dividend 16.7% to $0.14 from $0.12 per share quarterly. The forward yield is 1.5%. This is the 16^th straight yearly increase. Silgan is a Dividend Contender.

Danaher (DHR) increased the dividend 16.7% to $0.21 from $0.18 per share quarterly. The forward yield is 0.4%. This is the 12^th yearly increase in a row. Danaher is a Dividend Contender.

AMERISAFE (AMSF) hiked the dividend 7.4% to $0.29 from $0.27 per share quarterly. The forward yield is 1.9%. This is the 7^th consecutive annual increase. AMERISAFE is a Dividend Challenger.

Domino’s Pizza (DPZ) raised the dividend 20.5% to $0.94 from $0.78 per share quarterly. The forward yield is 1.1%. This is the 8^th consecutive annual increase. Domino’s is a Dividend Challenger.

Best Buy (BBY) increased the dividend 27.3% to $0.70 from $0.55 per share quarterly. The forward yield is 2.5%. This is the 7^th consecutive annual increase. Best Buy is a Dividend Challenger.

Werner Enterprise (WERN) hiked the dividend 11.1% to $0.10 from $0.09 per share quarterly. The forward yield is 0.9%. This is the 6^th consecutive annual increase. Werner is a Dividend Challenger.

Dividend Cuts and Suspensions List

I updated my dividend cuts and suspensions list this past week. The number of companies on the list has risen to 518. We are well over 10% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic.

The following companies were added to the list this past month: JD Bancshares (JDVB), Pzena Investment Management (PZN), DHT Holdings (DHT), Healthpeak Properties (PEAK), Corby Spirit and Wine (CBYDF), Antero Midstream (AM), and Danone S.A. ADR (DANOY).

Market Indices

Dow Jones Industrial Averages (DJIA): 30,927 (-1.80%)

NASDAQ: 13,192 (-4.92%)

S&P 500: 3,811 (-2.45%)

Market Valuation

The S&P 500 is trading at a price-to-earnings ratio of 38.8X and the Schiller P/E Ratio is at about 34.5X. These two metrics are down the past two weeks. Note that the long-term means of these two ratios are 15.9X and 16.8X, respectively. 

I continue to believe that the market is overvalued at this point. I personally view anything over 30X as overvalued based on historical data. Note that we are near 40X and valuation levels near the top of the dot-com era. However, the market is faced two tough weeks due to rising interest rates.

S&P 500 PE Ratio

Source: multpl.com

Shiller PE Ratio

Source: multpl.com

Stock Market Volatility – CBOE VIX

The CBOE VIX measuring volatility rose more than five full percentage points this past week to 27.95. This is the second week in a row the VIX has risen. The long-term average is approximately 19 to 20.

Source: Google

Fear & Greed Index – Inflation Rears Its Head

I also track the Fear & Greed Index. The index is now in Greed at a value of 48. This is down about 11 points this past week.

There are seven indicators in the index. They are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.

Stock Price Strength is signaling Greed. The number of stocks hitting 52-week highs compared to those hitting 52-week lows is at the upper end of its range.

Stock Price Breadth is indicating Greed as advancing volume is 1.26% more than declining volume on the NYSE. This is upper end of its range over the past two years but the indicator is weakening.

Junk Bond Demand is indicating Greed. Investors are accepting 2.15% yield over investment grade corporate bonds. The spread is down from recent levels indicating that investors are taking on more risk.

Market Volatility is set at Neutral. The CBOE VIX reading of 27.95 is a neutral reading.

Market Momentum is indicating Fear. The S&P 500 is 5.62% over its 125-day average. This is down and the S&P 500 is usually further above its trailing average than this.

Safe Haven Demand is in Fear. Stocks have outperformed bonds by 3.25% over the past 20 trading days. This is near the weakest performance over the past 2-years.

Put and Call Options are signaling Extreme Fear. In the last five trading days, put option volume has lagged call option volume by 51.87%. This is amongst the highest level of put buying in the past two years.

Source: CNN Business

Economic News

The number of weekly new unemployment claims were up with last week at 730,000. This is down materially by 111,000 from last week’s revised numbers. The 4-week moving average has been consistently above 800,000 for many weeks but is now trending down. For some perspective, one-year ago weekly unemployment claims were only about 220,000. Currently we are 3X – 4X the normal level. The seasonally adjusted insured unemployment rate was 3.1%.

The Conference Board Consumer Confidence Index® improved to 91.3 in February (1985=100), after increasing to 88.9 in January. The Present Situation Index— a measure of consumer sentiment for current business and labor market conditions—rose from 85.5 to 92.0. However, the Expectations Index— a measure of consumers’ short-term outlook for income, business, and labor market conditions— fell to 90.8 in February, down from 91.8 in January.  The percentage of consumers who said that jobs were plentiful rose to a three-month high of 21.9%. In addition, fewer respondents said jobs were hard to get, declining from 21.2% to 22.5%.

The Bureau of Economic Analysis reported the real gross domestic product (GDP) for Q4 2020 came in at 4.1%. While exports, nonresidential fixed investment, personal consumption expenditures (PCE), residential fixed investment, and private inventory investment saw an increase, they were partly offset by a decrease in government spending. Comparing 2020 to 2019 the report showed: Real GDP decreased 3.5% as compared to 2.2%, the price index for gross domestic purchases increased 1.2% as compared to 1.6%, the PCE price index increased 1.2% as compared to 1.5%, and excluding food and energy prices, the PCE price index increased 1.4% as compared to 1.7%.