Inflation has moved up in 2016, with most measures above 2%, the Federal Reserve target. Given the Housing Market Index (HMI) and other leading indicators to the economy remain positive, inflation is expected to continue to accelerate into 2017.
The chart above illustrates the year-over-year change for these four key measures of inflation. On a year-over-year basis, the median CPI rose 2.5% and the trimmed mean CPI rose 2.1% (both calculated by the Cleveland Fed based on data released in the Bureau of Labor Statistics (BLS) monthly report for September 2016). The BLS also reported for September 2016 that the CPI less food and energy rose 2.2%. Core PCE (August) increased 1.6% year-over-year.
Given recent trends in inflation, a 2.5% or above forecast for core CPI inflation in 2017 seems reasonable (see Chart II). Inflationary expectations for the 30-year T-Bond yield (yield on 30-year T-Bond less yield on 30-Year Tips) of 1.83% could well increase to 2.0% or 2.5%, which lifts 30-year T-Bond yields from 2.5% to 3.0% to 3.5% in 2017. Bond prices would then decline significantly on 30-year T-Bonds. Inflation-indexed 5, 10 and 30 year T-Bonds would appreciate due to a positive inflation adjustment.
How Does Higher Inflation Impact the S&P 500?
The Major Bull Markets in S&P 500 Driven by a Positive Differential Between ROE less COE
Analyzing the S&P 500 from 1990 to present (see Chart III), the ROE for the S&P 500 rose above its Cost of Equity (COE as calculated by IDCFP)* in June, 1993 and rose to a peak spread in March 2000. The S&P 500 rose from 452 to 1499, a 232% increase. The Housing Market Index (HMI) predicted the peak in ROE in 2000 and the decline in ROE below COE in 2001 and 2002 (see Chart IV).
The next bull market in the S&P 500, began in September 2002 as the ROE again rose above COE. The S&P 500 increased from 815 in September 2002 to 1421 in March 2007, the quarter the ROE less COE spread peaked at 9.32%. Stocks rose 74% in this bull market. The decline in ROE from 17.3% in 2007 to a low of 1.4% in 2009 was predicted again by the HMI (see Chart IV).
The current bull market was forecast by a positive ROE less COE spread in December 2009. ROE less COE spread rose from 2.73% on 12/31/09 to 9.78% on 12/31/2014. COE, meanwhile, declined from 8.07% on 12/31/09 to 4.31% on 12/31/2014. The S&P 500 rose from 1115 in December 2009 to 2059 in December 2014, an 85% bull market increase. However, the HMI continues to climb to new highs, indicating further economic gains and a recovery in ROE in 2017 (see Chart IV). ROE peaked at 14.8% in 2014 and receded to 11.7% estimated for the year ending September 2016. Since 2014, COE fell (due to lower interest rates) to 3.69% as of September 2016 from 4.31% in December 2014. The lower interest rates and COE allowed the S&P 500 to reach marginal new highs.
Higher inflation in 2017 and 2018 forecasts a 3.0% to 3.5% yield in 30-year T-Bonds, which, in turn, raises the COE to 5.0% to 5.5%. For the S&P 500 to maintain its current price to book value of 2.74 times, ROE must increase as fast as COE to 13.0% to 13.5%. A per share book value of $800 plus for the S&P 500 times 2.74 indicates a 2192 level for the S&P 500 (recent peak of 2.84 P/BV forecasts 2272).
A peak in HMI in 2017 and a decline in ROE in the face of a rising COE forecasts a decline in the S&P 500. Price to Book value in a declining market falls to an estimated 2.4 for an S&P 500 price of 1920 (a 10% correction). A bear market occurs with a major decline in ROE and price to book value per share drops to 2.0 times book (as occurred in 2009) for an S&P price of 1600 (a 25% bear market).
* COE as calculated by IDC uses general risk as demonstrated by the 30-Year T-Bond yield. A risk premium adjusts for another 50% of the 30-year T-bond and 20% of the 5-year standard deviation of the ROE to cover specific risk.
IDC’s next article discusses Price to Book value per share for the S&P 500, as well as, ROE compared to COE for the average of S&P 500 firms.