Submitted by Mark Spiegel
Don't Bother with Comparisons to the 1970s... They're Useless
Some folks believe that we're headed for a stagflationary era similar to
that of the mid-1970s to early 1980s, when inflation got out of control
and even nominal stock prices essentially went nowhere despite
significantly higher nominal earnings. The difference between then and
now, though, is that then the Fed wanted to control inflation, whereas now it's trying to create it.
That nasy inflation of the 1970s that we've all read about (and many of us are old enough to remember) began in 1973, when the CPI finished +8.7% vs. +3.4% for the previous year. It continued (dipping to as "low" as 4.9% in 1976 and climbing into double-digits in 1974, 1979 and 1980) until it was finally broken in 1982, when it declined to 3.8% from 8.9% in 1981. The way inflation was broken, of course, was via increasingly higher interest rates; the Fed Funds rate started 1973 at 5.75% and climbed to as high as 20% (!) in 1981.
Those high rates served (presumably, not intentionally) to compress stock PE multiples despite corporate America's generally much higher earnings. Specifically, the S&P 500 began 1973 (the beginning of the high-inflation era) at 118.05 and ended 1981 (the end of the high-inflation era) at 122.55, for a total eight year gain of just 3.8%, despite the fact that trailing nominal S&P earnings increased over that time from $6.17 to $15.18. Thus, 2003 opened with a trailing 12-month PE of 19.13 while 1981 ended with a trailing 12-month PE of just 8.07. The reason stocks went nowhere, of course, was who needed stocks when one could earn a high double-digit return simply by parking cash in the money market?
The goal of the current Fed, though, is to inflate away enough of the national debt to make it manageable. (The Fed doesn't really believe that at this poiint, additional QE can do much more for the "real" economy.) Thus, this Fed won't be providing the kind of higher interest rates that capped PE multiples in the 1970s. So, after perhaps an initial earnings squeeze due to compressed profit margins from higher input prices (i.e., if you want to short nominal stock prices, right around now may be your last chance), we may start to see higher nominal earnings as prices are increased while wages-- due to the international fungibility of labor-- are capped, along with either steady or expanding PE multiples.
What could cause higher interest rates (thereby crushing PE multiples and, presumably, stock prices)? Well, if the price of gasoline spikes north of $4, folks (and their politicians) may scream loudly enough to force the Fed to stop trying to "create" inflation. Or, of course, it could happen if the rest of the world suddenly stops buying our debt unless it gets better compensated for it (via higher rates). The fact that either of these things could happen (and, in fact, at least one of them may even be likely to happen) means that inflation-induced higher nominal stock prices in a very slow-growth economy are not a sure thing.
Thus, one might conclude (assuming that one believes that we're destined to remain in a slow-growth economy) that upside vs. downside risks in the equity market are currently somewhat equally weighted, with the resolution dependent upon whether or not the Fed is able to cap interest rates which, as a "by-product", would allow steady or expanding PE multiples to combine with inflation-induced higher nominal earnings, and thereby create higher nominal stock prices.