Transcript:
Easan Arulanantham:
Why does inflation makes stocks go down? And does it affect different kinds of types of stock differently?
Tom Vaughan:
Yeah, so the big theory behind inflation, making stocks go down. First of all, understand that it doesn’t always make stocks go down. It’s really high inflation or quick inflation, that makes stocks go down. So when you it’s the acceleration of inflation, that has the biggest impact, I saw a big study, it’s really fascinating. So and that’s kind of what we’ve had here, right, we’ve had this inflation that’s gone up very quickly. It’s a little bit, you know, of a weird scenario, because we have this pandemic, right, this isn’t a normal inflationary cycle, it could be partially temporary, they could figure out some of the supply chain constraints, you know, so we’ll see how that plays out. But high, fast growing inflation creates problems for stocks. But overall, the concept of inflation is an issue for stocks because of what the Federal Reserve does to fight it. So the Federal Reserve sees inflation’s they have two mandates, kind of trying to create full employment and then trying to keep inflation low. And the idea behind keeping inflation low, it allows companies a better chance to kind of plan, you know, with their expansions and different things like that, when inflation is, you know, one and a half to two and a half percent, companies are a lot more comfortable in their planning environment, you know, when inflation is at seven, and 10. And moving all over the place, it gets to be really difficult to figure out your projects. And so the Federal Reserve comes in and they start tightening up.
Again, they tighten up in three different ways right now. One, they’re cutting back on their stimulus, bond buying, right, they call it quantitative easing, their client cutting that back, and they can sell off some of the bonds that they’ve purchased, you know, and then the biggest one really is interest rate increases. So as they increase interest rates, the cost goes up for everybody. So if you’re using a credit card, and you’re paying the interest, it gets more expensive. If you’re gonna go buy a car that used to get for 1.9% loan, and now it’s 5.9% loan, less people buy cars, if you’ve ever mortgages were two and a half to three and a half percent on a on a house. And now it’s six or seven, lot less people buy homes and homes, that huge economic, you know, boom, because there’s so many people involved with building homes and selling homes and what have you. So when that drops down, that takes a piece of the economy. And then companies themselves that do borrow to grow, obviously, the cost of borrowing goes up. So the combination of all of these things slows down the economy, which is what they’re trying to do, a slower economy would have theoretically less inflation. There’s a lot of variables in here. But you know, these are general general generic terms. And so when you get this scenario where all of a sudden, you know, the economy slowing down quite a bit, obviously, earnings start to fall. And that’s the key driver for the stock market.
Now, keep in mind that they haven’t even raised rates, yet, the markets already kind of reacting and getting a little volatile. Because the market is a forward looking mechanism. It’s looking, you know, six to 24 months down the road and seeing a higher inflationary potential environment or higher interest rate environment, that could slow the economy down some. And unfortunately, this is combined in this environment right now, with some worry that the Federal Reserve could be fighting inflation, that doesn’t happen. Because say, omicron comes along at something like that, that slows things down by itself, or the supply chain that is causing so much as inflation now unwinds itself and gets much more efficient again. And I was said inflation comes down. So if you’re slowing down in the economy, that’s already going to slow down, you might have some problems there. So that’s always an issue too. There’s not always the Federal Reserve has been wrong a lot. And so there’s some concerns there that they’re, you know, on, going too slow, going too fast, you know, depends on who you talk to. So that that’s that’s the big issue with inflation as far as that goes. But in you know, we’ve always had inflation, we had a 12 year run from 2010 to, you know, till the pandemic here. And we really had some inflation all the way through there. So lower levels of inflation isn’t a big issue. It’s just higher levels, and especially spiking levels that create the most problem and maybe just more uncertainty in general, as far as that goes.
Last piece is that there becomes a competitive asset. So if I can get a treasury bond –I’m making this up– at 8% (ight now, the 10 year treasuries at 1.7 something percent). So it’s a long ways from that. If I get a 10 year Treasury that will pay me 8% a year, and the stock market’s averaging 11 I have virtually no risk in that Treasury and lots of risk in that stock market. So that becomes competitive asset class. So it’s a CDs or bonds or treasuries, those types of things start to pay such high rates, you know, people less people will buy stocks in that environment, just because, you know, there’s other safer places to go to get nearly the same rates of return, we’ve had just the opposite. One of the reasons I was so positive about this last year, being a great year, because there was still nowhere else to go, it was gonna be real estate and stocks, right? That could because the banks weren’t paying anything that’s starting to change this year, in my opinion, at least a little bit. So yeah, that’s, and then ultimately, the Federal Reserve raises rates raises rates, like we saw prior to 2008. If they overdo it, like they did in 2008, we end up with a big, you know, enough slowdown, in enough risk being taken, you can have an implosion in the financial system, like we did in 2008. So that late cycle, tightening is the scariest part to the market. And so that’s what’s kind of create creating some of this, you know, issues right now.
Easan Arulanantham:
Yeah, so how does that play into the value stock facility? Growth? Shock, you know, is, is, uh, you know, should I overweight, one of the other over the other based on a fight for inflation?
Tom Vaughan:
Yeah, well, first of all, you know, I think it’s important to realize that we might not have inflation. So I think a lot of people are marching down the road as if it’s a done deal. We’ve have had inflation, that there’s a likelihood that we would have inflation, but it’d be very careful about overweighting your portfolio based on what you think might happen with inflation here. And, or even you’re changing your bond strategy dramatically, I still stay very diversified. And we’re talking about the little pieces that you might move, deal with inflation. So for example, in our bond portfolio, our targeted pieces are in these Treasury tips, right treasury, insured protection securities, treasury inflation protected securities. And so the key there is, it’d be a little bit careful. But yeah, altogether, value theoretically does better in an inflationary environment than growth. And the real reason is because value has lower multiple P E ratio, so the price compared to the earnings. So if your price compared to earnings is nine or 10, versus another company who’s at 300, like some of these really high flyer growth stocks, it’s why you’ll see a lot of those high flyer growth stocks really come down, and has a lot to do with what they call the discount mechanism.
So it gets a little sophisticated. But if the payback period is 300 years, and you’re discounting back at a higher interest rate, the current value is lower. And there you would adjust theoretically, the price versus a payback period is 10 years, even at that same interest rate. Discounting back to current, there’s less impact on the price. And so you’ll often see value stocks do better in an inflationary situation. Although last year we saw a kind of like temporary move into the value area. And growth still, especially the big growth stocks still did well, because it’s really I’m telling you, these companies make hundreds of millions of dollars of cash flow. And so it’s hard to beat. That’s why I like the apples or what have you to even inflation impaired environment because, you know the earnings are still so fantastic, especially in a demand environment where we have a lot of excess cash on the sides that coming in so