?????? A virtuous, self-reinforcing cycle

??Market Strategy Flash

The famous investor, Warren Buffett, gave one of the simplest explanations about inflation’s impact on markets: “Inflation swindles the bond investor … It swindles the person who keeps their cash under their mattress, it swindles almost everybody.”

That’s why bonds and stocks cheered in response to this week’s calm inflation reports, which is a useful way to frame the outlook for equity valuations. Indeed, the change in the general level of prices in the economy is highly correlated to the stock market’s earnings yield or reciprocal of the price-to-earnings (P/E) ratio (see the chart below).

Specifically, US large market capitalization stocks received welcome news in the form of stable producer, consumer, and import price inflation, softer bond yields, as well as the possibility of a few more interest rate cuts from the Federal Reserve (Fed).

Moreover, the New York Fed reassures us that the primary core trend of personal consumption expenditures (PCE) inflation is down, helped by ebbing goods and housing prices. At a rate of 2.3% year over year (Y/Y), underlying PCE price inflation is close to the Fed’s 2.0% Y/Y inflation target, an observation that should help the inflationistas to relax.

In our view, a strong US dollar, persistent downside inflation surprises, and further Fed rate cuts should coax cash from the sidelines, thereby kindling a rally at the top of the capital structure (i.e., bonds). A lower discount rate could also support the bottom of the capital structure (i.e., stocks) in a virtuous and self-reinforcing fashion.

A strong USD, cooler inflation, and lower bond yields could support a high P/E

Sources: BLS, FRED, WCG, 1/15/25. Notes: USD = US dollar. EPS = Earnings per share.

Definitions

The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of goods and services.

The S&P 500 is an index that tracks the stock performance of 500 of the largest companies listed on exchanges in the United States. Indexes are unmanaged and cannot be invested in directly.

S&P 500 as reported EPS is income from continuing operations, also known as Generally Accepted Accounting Principles (GAAP).

A correlation coefficient indicates the strength and direction of a linear relationship between two variables, expressed as a number between -1 and 1. -1 is a perfect negative correlation, 0 is no correlation, and 1 is a perfect positive correlation. Essentially, it tells you how closely two variables tend to move together.

Disclosures

Important Information

Investment advice offered through WCG Wealth Advisors, LLC, an SEC registered investment advisor. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the companies as well as broad market, economic and political conditions. Stock investing involves risks, including fluctuating prices and loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Bonds are subject to availability, change in price, call features, and credit risk. Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

This is for educational / general purposes only, does not constitute investment, tax or legal advice and should not be relied on as such. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in making an investment decision for any individual. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The opinions referenced are as of January 16, 2025. These comments should not be construed as recommendations but as an illustration of broader themes.

Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Publication Date: January 16, 2025

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