The Key To The Long-Term Secular Direction Of Stock Prices

The Conference Board predicts that US economic growth will decrease from 5.5% in 2021 to 3.5% in 2022.

S&P 500 EPS growth is expected to fall from 44% this year to 6% in ‘22.

This leaves a lot of opportunity for the downside and almost none for the upside.

According to the Bureau of Labor Statistics (BLS), CPI rose 6.8% and PPI rose 9.6% year-on-year in November.

Of course, the Fed ultimately reacted to all this inflation by declaring in December that it would double the pace of its taper. 

But this is happening at a time when inflation is peaking. 

Meanwhile the yield curve is already rapidly heading towards inversion even before the tapering of QE has really even begun.

The spread between 2 and 10-year has already contracted from 159 bps at the end of March to just about 75 bps today. 

Meaning, by the time the QE taper is consummated, there probably won’t be very much room at all to hike rates before an inversion takes place.

But regardless, the fact remains that the biggest buyer and direct supporter of Mortgage-Backed Securities and Treasury Bonds, along with its stated support of corporate debt (including Junk bonds), will be exiting the market entirely come March ‘22.

This leaves a tremendously dangerous vacuum in place.

The Fed’s QE program has kept the massive real estate and equity markets afloat, as well as the $12 trillion worth of the corporate debt market.

The truth is, the solvency of nearly every developed nation on earth is contingent on interest rates that remain in the sub-basement of history.

Without state-owned entities, solvency and inflation concerns will combine to push yields much higher.

In the absence of inflation, central banks have been able to print enough money to ameliorate recessions, bear markets, real estate debacles, and solvency concerns-such as the European debt crisis circa 2012.

That leaves the Fed and Treasury with a dangerous dilemma.

The stock market and economy are caught in the middle.

This is why identifying inflation and deflation cycles are critical to understanding stocks.

Conventional stock market wisdom has promoted a fundamental relationship between P/E ratios and interest rates.

It has relied upon a key assumption that inflation is positive.

As reflected in this chart, P/E ratios increase when the inflation rate trends toward price stability (near 1% inflation) and P/E ratios decline when the inflation rate trends away from price stability.

The result is a “Y Curve” effect, where P/E declines into deflation despite low interest rates.

This effect is consistent with the modern dividend discount model since earnings and dividends would be expected to decline during deflation and therefore would result in lower valuations.

Therefore with P/Es at historic highs, the divergence away from stable 1% inflation could only mean one thing in the future: lower P/Es and stock prices.