Has the specter of inflation got you spooked? Recent headlines are filled with sightings. In this two-part series, let’s take a closer look at what to make of all the commentary, and what you can do about it as an investor. First and foremost, we caution against succumbing to fear or panic in the face of inflation. As usual, careful planning remains your best guide.

What Is Inflation?

Inflation is the rate at which a currency loses its purchasing power as prices increase over time. So, say a cup of coffee cost $1.00 twenty years ago. If the average annual inflation rate had been 2% between then and now, that same pour would now cost you $1.49. Various goods, services, and sectors often experience different rates of inflation at different times, but general inflation is usually calculated based on the Consumer Price Index (CPI), or a similar broad pricing index.

Recent headlines have been reporting a noticeable uptick in inflation. Superlatives like “best” and “worst” grab the most attention, so outlets have been abuzz with reports of how a 5% May consumer pricing surge was “the biggest 12-month inflation spike since 2008.”

Putting Inflation in Proper Context

Before you read too much into these recently rising numbers, it’s worth remembering their context. We’re comparing May 2021 to May 2020, when we were still deep into what The Wall Street Journal called a “screwy” pandemic economy. The WSJ explained, “If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track.”

Zooming out even further, the Federal Reserve’s 10 Year Break-Even Inflation Rate is one common estimate of the market’s expected average annual inflation rate for the next 10 years. As of mid-June, that rate stood at 2.3%. That’s up from the lower 1.2% rate expectation from mid-June 2020, but it’s still not eye-popping.

Which leads to another important point: Not all inflation is bad. In fact, a bit of inflation goes hand in hand with economic growth and reasonable interest rates for lenders and borrowers alike. A 2% annual inflation rate is typically considered a desirable norm for greasing the wheels of commerce, without destroying the working relationship between currencies and costs.

What if Inflation Runs Amok?

And yet, while inflation has its purposes, it’s concerning if it goes on a rampage. When it does, uncertainty has spiked as well, wreaking havoc on commerce, the economy, job markets, real estate, and financial markets. (Deflation—the opposite of inflation—can also upset the economy if prices drop too precipitously.)

Investors who were around in the 1970s may remember the last time the U.S. experienced red-hot inflation, and what it felt like when it spiked to a feverish 14.8% in 1980.

The New York Times described it as an era when “prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 percent, and interest rates on bank certificates of deposit approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.” While 12% CD rates may sound great, when interest and inflation rates are comparable, the real returns from even high-interest CDs essentially become a wash.

After the 1980 high-water mark, the Volcker-era Federal Reserve tamped inflation back down. So younger investors have heard of, but never experienced such steep inflation for such an extended time. Despite occasional alarm bells, inflation has mostly continued to hit the snooze button for decades. At least so far.

Next Up: What Can You Do About It?

What if inflation does get out of hand, and stays that way for a while? Depending on who you heed, the possibility ranges from unexpected, to possible, to a near certainty. In our next piece, we’ll cover why forecasts remain as fuzzy as ever, and how investors can best prepare for whatever may happen next. As usual, prudent planning is preferred over rash reaction.

With the general election approaching, many investors are worried about heightened volatility in the stock market. We have had several people reach out with three types of concerns: concern around an election without a clear winner (or a candidate not admitting defeat), concern around an election result different than their preference, and concern around general volatility.

This election is unique, but so is every election. That’s what makes it “news” and news moves markets. While the news is always different, the way markets react to news is fairly steady over time. In this piece, we analyzed market behavior in the 30-day period around each election over the last 96 years.

Starting 15 days before the election (a Monday in late October) and ending 15 days after the election (Wednesday in November) we looked at returns of the S&P 500 and the standard deviation of daily moves during that time.

In the 23 elections listed above, the average return over the month is 0.72%, which is slightly behind the 0.83% we’ve seen on a monthly basis over the last 95 years. The volatility (standard deviation of daily returns) during these 505 trading days was also slightly elevated, at 1.44% per day compared to an average of 1.20% (23,310 trading days since 1926).

The volatility is 20% higher, which isn’t a meaningful difference for a month. The return averages 0.11% less but is still rather positive and the difference is far from being statistically significant.

That message probably won’t allay the fears of those who feel this particular election is too unique to be captured by historical data. Still, it should provide a degree of comfort that returns around elections have historically been positive and close to average market returns.

Two things are worth remembering. First, markets move on events that differ from expectations. The stock market didn’t drop in 1984 because Reagan was reelected or in 2008 because Obama was elected, both of those outcomes were expected. The market dropped for other reasons. Second, a company is worth the present value of all future profits. Perhaps the market will be volatile around this election, but for stocks to drop, and stay down, the market must decide expected future corporate profits are worth less.

At Rockbridge, we believe the best course is to stay invested through the election, we are recommending that to all clients and doing it with our own investments. However, if you can’t sleep at night you should reach out and have a conversation with your advisor.

Departing thoughts: I recently overheard someone intending to get out of the market now and buy back in at a lower price. They said they were hoping to “make” a little money from the trade. They should have said “win” a little money. Timing the market is a zero-sum game, and a game of chance, it’s not earned money and if the market doesn’t behave as desired money will be lost.

Many of our clients have been asking why the stock market has recovered so much in the last two months while the economy is shrinking, and unemployment is hitting record highs. Implied in the question is whether the stock market is “overvalued” and will drop in the near future. The stock market may drop in the future because of new information and events that have yet to happen, no different than any other day. Here we will try to put the market’s actions into perspective and provide an explanation for current share price.

The best way to look at market valuation is through fundamentals. The price of a stock, or the market as a whole, is the value of all future earnings, from now until the end of time, discounted back to today. If you’re retired and think “But I don’t have forever”, worry not because the market does and that’s what prices stocks.

Our valuation equation consists of earnings (numerator) divided by a discount rate (denominator). Earnings will be less this year, though the degree of the drop and its longer-term impact are open to debate. According to FactSet Market Aggregates, analysts are expecting a 22% decline in earnings for 2020 (still positive just smaller than 2019), with 2021 reverting to just shy of what 2020 was supposed to be. If this were to hold, and using a 12/31/2019 valuation baseline, the S&P 500 should be around 3,000 – a 2.7% discount from where it stands today. A larger decrease in earnings or a prolonged reduction in earnings growth would harm stocks further.

Earnings are only half the equation. Even a slight change to the discount rate can meaningfully alter equity valuations. Were the discount rate to drop from 8.2% to 7.7% equities would increase 9.1% in value. The most indisputable thing affecting discount rates at the moment is the drop in inflation expectations and bond yields. If inflation is lower and you’re getting a lower return from a safe investment like a treasury bond, it stands to reason the market will demand a lower return from the stock market, meaning a lower discount rate and higher stock prices.

Many think of stock market returns as an “equity risk premium” or the extra return you get by bearing the extra risk associated with the stock market. Since 1926, the S&P 500 has returned an annualized 7.3% more than inflation and 5.1% more than five-year treasury notes. At the start of the year, the 5-year treasury note was yielding 1.67%, which was about the same as 5-year inflation expectations. Now the five-year note is at 0.33% and five-year inflation expectations are 1.06%. If real bond returns are lower, you’d expect real stock returns to be lower which is manifested through a lower discount rate and higher valuations.

Some argue the market’s increased volatility should mean a higher discount and lower stock prices. This argument has merit and may be partially responsible for lower equity prices. However, others argue the recent fiscal policy of the legislature and monetary policy of the federal reserve has been faster and more accommodating than previously expected. With the government quick to intervene to protect corporate profits and prevent bankruptcies perhaps stocks are less risky than previously thought and the discount rate again should be lower.

Things that decrease future risk, lead to a lower discount rate, and lower expected returns.

In the appendix of this article we run through several scenarios adjusting corporate earnings and discount rates to assess their impact on S&P 500 fair value.  Some interesting observations:

  • At the end of 2019, the price of the S&P 500 Index, projected earnings (analyst expectations in the near term and historical real growth in the long-term), implied a discount rate/expected return of 8.2% over a 50-year window.
  • A temporary reduction in earnings, and a slight decrease in the discount rate can explain current market valuations.

No one knows what the market will do in the coming months, but it’s wrong to think the market must go down. Things like future earnings and discount rates are impossible to know and subjective to each persons’ point of view, but it is not difficult to get to current equity values under reasonable assumptions. The following are key takeaways:

  1. Markets are forward-looking and move when events transpire differently than expected.
  2. Earnings drive prices but one bad year will not make an enormous impact as long as future years return get back close to expectations.
  3. The rate at which future earnings are discounted is very important. A lowering of the discount rate will cause market prices to increase substantially and there is good reason to believe the market’s discount rate is lower today than it was six months ago.


Key Terms

Discount Rate: The interest rate used to calculate the present value of cash flows in the future.

Earnings: Corporate earnings, either of a single stock or a weighted earnings of a whole index. For all examples below, we assumed a long-term growth rate of 3.5% which represents the 2% real earnings growth rate we’ve seen over the last 140 years, plus the 1.5% current long-term inflation expectation.

PV of E: The present value of earnings are the future earnings that have been discounted back to today’s dollars by the discount rate.

Value: This is the sum of the “Present Value of Earnings.”

The following table shows the value of a fictitious stock that will earn $5 next year, those earnings will grow 3.5% a year, and the discount rate applied to the stock is 8.5%.




If you sum the “PV of E” (present value of earnings) for the next 50 years you get $90.55. We cut the chart after 11 years to make it fit on one page. The most sensitive variable is how much larger the discount rate is than the growth rate. In this case it was 5%. If we lowered that to 3% (say a 4.5% growth and a 7.5% discount rate) the value jumps to $126/share. If we widen it to 7% it drops to $69/share. What makes valuing stocks difficult is that no one knows future growth, or the market assigned discount rate. A critical thing to note, the discount rate is the expected return.

We can put this formula to practice with the S&P 500 looking back to the end of 2019. At the time, the S&P 500 was trading at 3,231 with expected 2020 earnings of 170.





Using the same method of summing the next 50 years, we get an index value of 3,231 (the index’s close on 12/31/2019) from a discount rate of 8.2%.

With this premise in place, we can explore different scenarios. First let’s look at the consensus estimates by Wall Street analysts. They are forecasting the S&P 500 to make 127/share in 2020, with 2021 being close to 2020’s original forecast or 165/share in earnings.




Were that to happen we should see an S&P 500 valuation of about 3,000 or 1.7% below today’s prices. This is assuming no change in the discount rate. This may be what the market is expecting and how it’s currently priced.

But what if the effects of the Coronavirus are substantially greater than the market is expecting. The following scenario assumes earnings are 50% below expectations in 2020, stay at the same level in 2021, and then revert to expectations in 2022 and beyond.




We now get a fair value that is 8.2% below where the market is currently trading. To get a market valuation down in the 2,300s like we saw near the bottom  in March, earnings would have to come in substantially below expectations and would need to have a lasting impact through the rest of the decade, and likely we’d need an increase in the discount rate (we revisit this later).

The prior scenarios are all assuming a change in earnings but not a change in the discount rate. If the discount rate is altered, even slightly, then equity valuations would be meaningfully changed.

If earnings forecast came in on top of expectations, but the discount rate was lowered by 0.70% to match the decrease in the real yield of treasury bonds, we’d actually see a valuation near the record highs we saw in February.





The next table incorporates a more severe earnings decrease combined with a reduction of the discount rate. The result is an equity valuation about 3.2% above what we see today.





If you’re pining for an equity valuation around the lows we saw at the end of March, the following table is one way to get you there.




We’d need very depressed (50%) earnings for the next two years, followed by a year that gets us halfway back to what analysts are currently expecting for 2021. Furthermore, the discount rate would have to increase to 9.2% which would happen if investors became more nervous because of stock market volatility or if inflation were to increase substantially over expectations.

It is important to remember the relationship between discount rates, valuation, and expected returns. Most people’s Intuition would say to root for a lower discount rate in order to increase equity valuations. However, a lower discount rate means lower expected returns in the future. On the flip side, a larger discount rate would cause the market to drop, but you’d be compensated in the long run by greater expected returns going forward. For the market to do well in the long-run companies need to create wealth and make money.

Rebalancing the allocation among risky assets in your investment portfolio is an important discipline.  It provides a structured way to maintain consistent risk exposure over time and forces us to “buy low and sell high” when it is not always the comfortable thing to do.  This quarter is a good example, in the midst of crashing stock prices, and record volatility in markets, we have been selling bonds to buy stocks in our portfolios.  Buying stocks during all this uncertainty can feel uncomfortable if not downright frightening, but here are a couple of things to keep in mind.

Cash never “goes to the sidelines.”  If you listen to the talking heads of financial news-media, it can sound like all investors are reducing their exposure to stocks, and hoarding cash to buy back in when prices are lower.  But that’s not the way markets work!  Whenever a share of stock is sold, another investor buys it.  When there are more sellers than buyers, prices fall to clear the market.  Warren Buffet’s famous saying bears repeating now, “Be fearful when others are greedy, and be greedy only when others are fearful.”  Another famous quote strikes a chord as well, “In bear markets, stocks return to their rightful owners.”  Long-term investors want to be the owners of stocks and down markets are an opportune time to buy.

When stock prices drop, expected returns increase.  It may at first seem counterintuitive, but the math is fairly straightforward.  The value of a stock, or any other asset, can be described as the discounted present value of all future cash flows.  There are two factors that influence the value of a stock:  future cash flows and the discount rate.  When cash flows become more uncertain, we apply a higher discount rate.  Logically, a rational investor would pay less for an uncertain stream of cash flows than a stream with greater certainty.  The discount rate is a reflection of expected returns.  When risk and uncertainty increase, investors demand a higher expected return.  Over the past two months many stocks have decreased in value by 30% or more.  Some of the decrease in value is driven by an expectation of lost revenue and profits (future cash flows) resulting from Coronavirus’ shutdown of the global economy.  However, some of the decline is due to fear and uncertainty, which translates to a higher discount rate.  Both of which have a negative impact on stock valuations.  In turn, buying stocks at today’s prices comes with the expectation of higher rates as compared to two months ago.

Rebalancing is a valuable and important discipline.  If you still have questions about rebalancing, or worry about the appropriateness of your target allocation, talk to your advisor.

Stock Markets

The damage to stocks from the Coronavirus pandemic is shown in the chart below as all markets are down dramatically. The domestic large cap stock market (S&P 500), driven by the largest tech companies, held up a little better.  Except for this market, this quarter’s falloff brought the five-year returns to essentially breakeven and we must look to the ten-year numbers for returns that generally compensate for risk.

We are in uncharted territory and will be for a while.  It’s not the usual economic “slowdown”, but a “shutdown”.  Ben Bernanke, Fed Chairman during the 2008 financial crisis, likens to a natural disaster not a depression. Markets are clearly discounting the massive uncertainty of the trajectory of the Coronavirus pandemic, the global economic impact and government’s response.

It is reasonably clear that this health crisis and our response will alter the future economic landscape. There will be ups and downs as we move from where we are to where we are going. Today’s prices reflect current information about what is known and what is unknown about this journey. The expected return implied by these prices is not only positive but is apt to be better than what we have seen in the past to compensate for the greater risk in this period of heightened uncertainty. There is no reason to conclude this expected return won’t be realized eventually. To earn these returns means to remain committed to established investment plans.

Bond Markets

A yield is what you earn by holding a bond to its maturity. It has been shown to be a reasonable proxy for the return expected.  Changes in yields drive returns – falling yields positive, rising yields negative.  The longer a bond’s maturity the greater the impact a given change will have on prices and returns.

You can see to the right how yields have dropped over the last quarter.  It’s only at maturities greater than five years when yields are better than zero.  The falloff in bond yields of over one percent since last quarter reflects the Fed’s reduction in interest rates and its announced commitment to provide liquidity during this crisis.  In addition to the activities of the Fed, yields at the longer end are consistent with a desire to avoid risk and the expectation of low rates well into the future.  We have the Fed’s playbook from the 2008 liquidity crisis to give a sense of how they will apply the various tools.

The impact of the massive stimulus package is another uncertainty. No doubt we’ll see increased deficits, which is usually accompanied by inflation.  However, inflation has been benign over the last ten years as we worked through the effects of the last recession. The same could hold true this time around, although the deficits are going to be greater. The bond markets are telling us to expect that inflation will remain in check.

Risk and Uncertainty

Uncertainty can’t be measured, but risk can as both are associated with an unknown future. The stock market, where investors buy and sell based on an uncertain future, is an example.  Using historical data, we can construct expectations and a range of outcomes, which can be used to measure stock market risk.  A pandemic is new territory and if we accept that how markets deal with uncertainty is reasonably consistent through time, then history provides some insight into describing what’s ahead.

Today it’s the uncertain trajectory of the Coronavirus.  As more data is gathered through the ongoing testing’ the uncertainty is translated into measurable risk, which is then reflected in expected outcomes and variability. While the stimulus package signals Congressional support in lessening the economic fallout, there is not much history in implementing a package of this magnitude. Be prepared for a trial and error process, and volatility.

Where are We?

It is hard to imagine what we are going through won’t have a lasting social and economic impact.  The level of expected unemployment claims and government spending is new territory. The highest priority right now is to reduce the uncertainty of the health crisis. It will take time to expand the testing to better understand this pandemic and for “social distancing” to begin to work.  In the meantime, commitment and perseverance is our immediate future.

Markets look to the future, which is significantly murkier than a month ago.  It may be a while before the future looks much clearer.  While especially difficult in the face of today’s falloff, the time-worn prescription for investing in these times continues to be apt – maintain established commitments, endure the volatility in the near term and expect positive returns for bearing these risks over the long term.