Market Health

Why You Should Pump the Brakes on Inflation Panic

The markets are grappling with inflation fears.

And this has triggered a maelstrom for investors.

In April, consumer prices rose 4.2%. This was the largest increase since September 2008.

Cue the dramatic music… Dun-dun-dun.

And inflation has emerged as such a hot topic that, through May 14, 175 companies in the S&P 500 Index have mentioned the dreaded word on their earnings calls this quarter. This is the largest number of companies to do so since 2010!

S&P 500 Companies Meaning Inflation on Earnings

Of course, once all is said and done, that number will likely be even higher.

And there’s one sector getting hit the hardest by inflation… but the subject is barely being mentioned by its CEOs.

How Tech Got Too Expensive

Tech company shares have been pummeled by inflation fears.

In fact, the Nasdaq Composite is in its fourth week of decline and has suffered its second major pullback this year because of these fears.

Nasdaq vs S&P 500 YTD

Still, the tech-heavy index is positive for 2021, even though it trails the S&P 500 by a fairly large margin.

Though, it’s interesting to note that 84% of consumer staples companies and 75% of materials companies on the S&P 500 have mentioned “inflation” on their earnings calls.

That makes sense because those sectors are directly affected by inflation or are causing inflation. For example, lumber prices are at record highs, crude oil prices are surging and food costs have jumped year over year as the economy reopens.

Yet only 12% of tech companies have talked about inflation on earnings calls, even though they’re arguably the most affected right now by the fears.

This has led many investors to ask, “Why are tech companies getting creamed by rising inflation?

In the most basic terms, they are revaluing.

Most high-growth companies – tech stocks included – operate at a loss. Investors are okay with this and are willing to pay a premium on their shares now, despite those losses, for the prospect of a higher cash flow in the future.

Well, if there’s rising inflation – meaning $1 today will have less buying power in the future – then those high-growth companies operating at a loss are even more expensive compared with projected cash flow down the road.

Those valuations become more and more stretched until it reaches a point where investors declare, “This is too rich for my blood!”

They then rotate out of high-growth stocks and into stocks trading at a value to future growth.

The result is a steep sell-off until an equilibrium is reached.

But when will that be?

Well, it is reached when inflation is recognized as temporary or transitory, meaning it’s rising much slower than expected, or when tech stocks fall so much they start to look cheap – or, at the very least, more attractively priced to that inflation-adjusted growth.

So if you’re wondering why those tech companies that are beating earnings estimates are falling, that’s why.

But here’s why I think inflation fears are overblown…

Pain at the Pump… and Lot

One of the biggest drivers in the consumer price increase last month was energy prices.

Energy prices were up 25.1% during the 12-month period ending in April.

Gasoline prices were up 49.6% (and have headed higher in May because of the recent ransomware attack on Colonial Pipeline). And natural gas prices – thanks to Winter Storm Uri – were up more than 12%.

Removing food and energy costs from the equation, consumer prices in April were up 3%. That’s larger than the 1.6% increase we saw in March. But there’s another outlier to consider…

Used cars.

The single largest contributor to consumer price increases in April – minus food and energy – was the uptick in used car prices.

Over the past year, these have jumped a staggering 21%!

It’s all part of this strange domino effect playing out.

And it illustrates how interconnected so many industries in our modern world are.

COVID-19 forced the global economy to grind to a halt. Businesses closed. Plants were shuttered. Workers were laid off or furloughed.

But it did not turn out to be the economic apocalypse that so many feared. Offices shifted online – as did storefronts. And to operate in this new virtual world, people started ordering new computers and peripherals in increasing volumes.

Unfortunately, semiconductor factories had been closed. These reopened and raced to fill the gaps and meet demand, but new 5G phones were launched, new video game consoles hit virtual store shelves and automakers started making “smarter,” more tech-laden vehicles.

Already behind, the chipmakers couldn’t keep up. And each day, they fell a little bit further off the needed pace.

The world began wrestling with a shortage. Not one of food, crude or water… but of semiconductor chips.

Front and center of the shortage is the automotive sector.

General Motors (NYSE: GM) announced it was suspending or reducing production at three plants in direct response to the shortage. There simply aren’t enough semiconductors to make cars.

With fewer new cars and prices surging for the new cars that are available, used cars have become one of the hottest commodities on the planet.

So, yes, all of this is due to inflation.

But ask yourself: Is this real, long-term inflation, or is it something more temporary?

Are used car prices going to continue increasing at this pace forever? Probably not. I did lay out my argument for raising my 2021 oil price forecast back in March, but that’s not a multiyear problem.

Expensive markets – like the one we have now – are more susceptible to sell-offs triggered by inflation risks. But there’s always a moment when investors come to their senses and recognize that the potential return of “overpriced” stocks outweighs the yield on 10-year Treasurys.

It’s going to be choppy for a bit. But it’s a good idea to be making a list of high-growth names to own for the future. They’re likely some of the few assets trading at a discount now.

Here’s to high returns,

Matthew

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