The stock market has been falling recently because of this little thing called inflation — and, quite frankly, the drop makes sense. Simple mathematics says that if today’s red-hot inflation doesn’t go away, the S&P 500 will drop 20%.
Really. If inflation stays hot, the stock market will crash.
But here’s the thing: Inflation won’t stay hot. It’s going to decelerate meaningfully over the next few months. And instead of a stock market crash, we’re going to get a stock market boom!
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Here’s the story.
Inflation has been red-hot. We all know that. Now, the big debate is where inflation goes next. And that’s an important debate because the answer will determine whether stocks drop 20% or rise 10%.
Let’s say inflation stays hot. That means the Federal Reserve could hike rates seven or eight times this year. In such a scenario, the 10-year Treasury yield could easily run toward 4%. Based on historical standards, our analysis suggests that a “fair” earnings multiple for stocks is about 16X in a world with that yield.
Calendar 2022 earnings estimates for the S&P 500 currently sit at $225 per share. A 16X multiple on that implies a S&P 500 price target of 3,600 — a 20% drop from current levels.
But let’s say inflation cools off. That means the Fed may only hike rates once or twice this year. In that case, we’re looking at a 10-year yield of around 2%. Our modeling suggests a fair earnings multiple of 22X in that world. A 22X multiple on $225 earnings per share implies a S&P 500 price target of 4,950 — a 10% rise from current levels.
So which is it going to be?
Is inflation going to stay hot and kill the market?
Or will it cool off and power a big stock market rebound?
We’re very confident in the latter, which is why we believe now is a great time to buy tech stocks.
Inflation Will Cool
Our confidence here stems partly from yesterday’s Consumer Price Inflation (CPI) report.
Sure, the print was hot. January CPI rose 7.5% year-over-year (versus 7.2% expected) and 0.6% month-over-month (versus 0.4% expected). The core numbers topped estimates, too. Those numbers were hot enough to spark a ~2% drop in the stock market.
But there are three reasons why we aren’t concerned about yesterday’s ostensibly red-hot CPI print and, instead, are bullish that it means slowing inflation trends are on the horizon.
One, the month-over-month rise in CPI (+0.6%) was largely stable in January relative to December. This continues what has been a multi-month downtrend in inflation rates and shows that we are still on track to — within the next few months; perhaps even next month — fall into the historically “normal” month-over-month CPI range of 0.0% to 0.4%.
Falling back into that range will be a huge step toward normalizing today’s hot inflation trends. We remain on track to do just that well before summer, despite yesterday’s headline CPI beat.
Two, the big drivers of January’s inflation were transient and should phase out in February and March. That is, the biggest drivers of the uptick in inflation in January were food prices, oil prices, and transportation prices.
Food is up because of a unique U.S.-Mexico law change that reduced throughput of vegetables and fruits into the U.S.
Oil is up because of harsh winter weather in the U.S. and geopolitical issues in Europe.
Transportation is up almost exclusively because of omicron-driven sickness, which is creating labor shortages.
But that law change has now been fully integrated. Weather is already improving. Geopolitical tensions in Europe are easing, and omicron is fading — meaning that the drivers of January’s “inflation acceleration” will disappear, likely this month and assuredly by March.
To that end, we think that this uptick in inflation is very temporary.
Three, one of the biggest drivers of the recent inflation surge — new vehicle prices — fell flat in January. That is, thanks to the semiconductor chip shortage creating a short supply of new cars, prices have been rising very quickly over the past few months. Specifically, new-vehicle prices had risen by more than 1% for eight straight months, which pushed demand into the used-car market — and has caused used-car prices to soar, too.
However, in January, new vehicle prices were unchanged month-over-month, indicative of an improving supply chain situation in the auto market. New vehicle prices should start falling over the next few months, which will likely bring auto demand back into the new-car market and cause used-car prices to drop.
Incoming Market Surge
Broadly, then, we see one of biggest drivers of recent inflation — car prices — turning into a deflationary force over the next few months.
Overall, we think the bulk of evidence today strongly suggests that inflation is cooling — not heating up — and that this cooldown will accelerate meaningfully over the next few months. This should result in sub-2% inflation by the end of 2022.
If so, then the Fed won’t hike rates that many times this year. Treasury yields will stop spiking. Stock market valuation multiples will remain elevated. Earnings growth will remain robust, and stocks will surge.
However, in the event things do play out like this, certain stocks will surge a lot more than others. Some stocks will rise 5% or 10%. Other stocks will rise 50%, 100%, or more over the next 12 months alone.
You want to own the stocks that will soar in 2022.
Find out the names and ticker symbols of those stocks — the best stocks to buy as inflation cools down over the next few months. And you can own the stocks that will soar this year.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.
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