Inflation or just plain old valuation?

Michael Rudd, CFA | President, CEO and Portfolio Manager

If you have been following the markets this week, you have probably noticed the global equity volatility.  There has been a number of reports in the financial press that indicated it started with a tough jobs report last Friday and then continued with inflation concerns. At the beginning of the week, expectations of a higher inflation print on Wednesday drove global technology stocks lower along with general equity and commodity markets.

The Non-Farm Payrolls Report was a bit of a miss last Friday with the market expecting that the economy would create 1 million jobs. Unfortunately, it only created 266k. There were also anecdotal news reports of employers indicating that positions are going unfilled because they are unable to find people. Indeed, the JOLTS Job Opening survey reported that there are currently 8.1 million job openings, which is an all-time high. With respect to inflation, the US CPI number came in at 4.2%. That was much higher than the 3.6% expected and the 2.6% from last month (keep in mind the US Fed target is 2%). Also, on Thursday, Produce Prices came in high at 6.2%, well ahead of last month’s reading of 4.2%. What strikes me about all this data is that it was expected and is rather short term, so it is hard to believe that this is the reason for volatility.

  • Figure 1 presents the earnings yield on the S&P 500 vs the US 10yr treasury yield. As you can see, the earnings yield (the earnings per share divided by stock price) on stocks is well below the average and at a low since 1987. It is also well above the bond yield, where it has been since 2001. Stock prices are indeed high on a historic and relative basis.
  • Figure 2 presents 5-year breakeven and 5-year US Treasury yields. As you can see, while breakevens are high, relatively speaking, this is not new information and the actual yield on the 10yr has not changed dramatically.

“This means that” we suspect that the volatility from last week was mostly likely related to stretched valuations rather than a sea change in the view of inflation and employment data. We used the volatility to add to positions and adjust portfolios where we felt that there were good valuations in the companies that we follow on a regular basis.

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