Why Stocks Are At All-Time Highs Even As Inflation Remains Far Worse Than Pre-Pandemic Levels

 

Investors have proven fearless of the prospect of lingering high rates.

Less than two years ago, it was considered all but certain the stock market would go through an extended period of pain as inflation roared to its highest level since the early 1980s, but Wednesday was the latest indication this wound up being far from the truth, with the S&P 500 setting another record despite uncomfortable inflation very much remaining in the picture.

KEY FACTS

The S&P 500 topped 5,300 for the first time ever Wednesday, rallying 1% after the Labor Department revealed core inflation fell to its lowest level since April 2021 at 3.6%.

That’s still the worst inflation prior to this inflationary cycle since February 1993, and interest rates remain above 5%, their highest level since 2001.

The stock rally comes as the market largely expects both inflation to subside and rates to come down, but the conventional wisdom that high inflation and elevated interest rates will cause stock market pain makes the massive stock gains seen over the last two years more challenging to justify.

Inflation is about 50% worse than it was prior to the pandemic and rates would still be about two times higher than they ever were from 2008 to 2020 even if the Fed does move forward with the two 2024 cuts currently priced in by the futures market.

Monetary policy is improving but far from ideal, yet stocks are hotter than ever, with the S&P up around 30% since rate cuts began about two years ago, so what gives?

In short, investors are comfortable paying more relatively to get in on the action: The S&P’s price-to-earnings and price-to-sales ratios, which measures the 500-stock index’s aggregate market value to companies’ annual profits and revenues, are at their highest levels since the turn of the millennium, an era often criticized for the pileup into technology stocks referred to as the dot-com bubble, other than a brief 2020-21 blip for the valuation metrics as companies’ performance drastically declined during the early stages of the pandemic.

Still Plenty Of Work To Do To Get Inflation Back To Normal 

Core Inflation

Year-over-year change in consumer price index, excluding food and energy.

Hopes For Fed Cuts Restored 

SURPRISING FACT

Profit growth has yet to catch up with the valuation expansions—trailing 12-month S&P earnings during 2024’s first quarter are actually lower than they were two years ago—meaning the market is pricing in significant longer-term earnings upside, largely led by artificial intelligence-related optimism. To correct this apparent dissonance, look no further than AI leader and investor favorite Nvidia, whose 78 price-to-earnings ratio is about three times higher than the S&P average now, but its shares trade about 20 times its projected earnings in 2028. That would be a far more reasonable price-to-earnings valuation, but that would mean Nvidia expanded its profits from 2023’s $4 billion to 2028’s $109 billion, according to average analyst forecasts compiled by FactSet.

KEY BACKGROUND

Higher rates typically weigh on stocks as they make the debt financing most companies use to finance operations more expensive. Higher inflation typically drags down stocks as companies face higher wholesale prices to manufacture goods and consumers often are forced to spend more carefully. The S&P’s price-to-earnings valuation is about 25% higher than it was in early 2020, when rates were below 2%. Contributing to the bullish sentiment is that the labor market has remained strong as inflation has come down, spitting in the face of the recession forecasts pervading much of 2022 and 2023.

CHIEF CRITIC

Inflation is far from disappearing, as we are “far” from seeing “evidence of sustainable progress in the inflation fight,” Vanguard economist Roger Aliaga-Diaz wrote in emailed comments.