How Inflation Fuels Bargain Hunting

Source: Kailash Capital, LLC, Yale University, Compustat. https://kailashconcepts.com/. The chart above shows S&P 500 P/E from 1/1/1935 to 4/30/2022. Note: Data prior to 1983 derived from Yale University, Post 1983 data derived from Compustat. Price/Earnings Ratio of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. Consumer Price Index (CPI) is the most widely used measure of consumer price inflation. The CPI measures the average change over time in the prices paid by urban consumers for goods and services. The Bureau of Labor Statistics (BLS) of the U.S. Department of Labor collects the CPI price information and calculates the CPI statistics.  All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.

Late last year, investors who were clinging to the hope that inflation might be temporary took solace in the fact that real Treasury yields remained negative, a sign that bond investors might not be that worried about inflation. At the time, we posed the question: What if the predictive prowess of real Treasury yields was missing the mark? And what if inflation is here to stay? 

As it turns out, last year’s Treasury indicator may not have been reliable after all, as yields on 10-Year TIPS (Treasury Inflation Protected Securities) started turning positive in April. If this is a sign that inflation may persist, what does this mean for investors?

Ironically, history shows that in periods of rising consumer prices, the one thing that typically goes down is the price that investors are willing to pay for each dollar of corporate earnings. As the chart above shows, rising consumer prices have had an inverse relationship with stock valuations throughout history. In the mid to late 1970s, when CPI jumped dramatically, the S&P 500 Index’s price/earnings ratio sank to single digits, as inflation made investors pay attention to what they were paying for when selecting stocks.

We believe this newfound interest in valuations presents an opportunity for active investors who focus on fundamentals. It should also cast a spotlight on undervalued stocks especially among small caps, which have been largely overlooked, relative to large caps, for much of the past decade. There is historic precedent for investors to turn their attention to small cap value after the bursting of a bubble and amid inflation. After the end of the so-called Nifty Fifty era, when consumer prices soared from roughly 1975 through 1979 and valuations plummeted, small-cap value stocks posted annualized returns of more than 36%, almost triple the gains for large-cap growth stocks.