INFLATION THIS YEAR has been running at more than four times the Federal Reserve’s target of 2%, forcing the central bank to raise interest rates multiple times. As a result, both the stock market and the bond market have been struggling. This has investors searching for alternatives.
At the top of the list for many people is gold, which gained a reputation as a bulwark against inflation in the 1970s. During that decade, when inflation was running hot, gold rose eightfold. More recently, gold climbed nearly 25% when COVID-19 first emerged in 2020.
Gold, however, also has a habit of being erratic. After its strong 2020 performance, gold dropped 4% in 2021. So far this year, it’s dropped a further 8%. What’s going on? As I’ve discussed before, gold lacks intrinsic value. Unlike stocks, bonds or real estate—which do have intrinsic value—gold doesn’t produce dividends, interest or any other kind of income. Gold is worth only what the next person is willing to pay for it, and that can vary wildly. This calls into question its inflation-fighting ability. That’s why I don’t recommend owning gold—except as jewelry.
If gold isn’t the solution, how can investors protect their portfolios in today’s inflationary environment? The most obvious answer: Treasury Inflation-Protected Securities, or TIPS. These are U.S. Treasury bonds that offer built-in inflation protection. Today, the five-year “breakeven rate” on TIPS is about 2.4%, meaning that TIPS prices assume inflation will drop substantially from today’s 8% or 9% level. If inflation over the next five years turns out to be higher than 2.4% a year, TIPS investors will do well. Since the jury on inflation is still out, I think TIPS are a good idea for most investors.
A close cousin of TIPS are Series I savings bonds. These must be purchased directly from the Treasury, there’s typically a $10,000 cap on annual purchases and you can’t sell them in the first 12 months after buying. Aside from those limitations, Series I bonds are another good way to shore up a portfolio against inflation. The rate on new bonds today is an annualized 9.6%, which is guaranteed for six months and then varies with inflation thereafter.
TIPS and I bonds make sense as part of an investor’s bond portfolio. But I don’t see either as a cure-all. After all, they’re still just bonds. Beyond their inflation adjustments, they offer very little upside. For inflation protection that carries the potential for more robust growth, there’s another asset class to consider: stocks.
This might seem surprising. After all, stocks have taken it on the chin this year. That’s true, but I don’t see this as a permanent condition. To understand why, it’s worth reviewing the fundamental driver of share prices: the profits of the underlying companies.
If you were to look at a chart of the S&P 500 index over time and lay it side-by-side with a chart of the S&P companies’ combined profits, you would see that they mirror each other quite closely. The relationship isn’t perfect. But if you take a longer-term perspective, market prices—on average—tend to follow corporate profits.
What are we seeing in corporate profits today? This is where it gets interesting. Read the headlines, and you might think companies are in trouble, struggling with higher costs for energy, raw materials and payroll. Those factors don’t seem like they’d bode well for stocks.
But that would overlook a critical factor: companies’ ability to raise prices. Consider Hershey. The cost to make its candy products has increased this year. But at the same time, it’s been able to pass a good bit of these increases along to customers in the form of higher prices, thus preserving much of the company’s profit margin.
Some companies have more of an ability to raise prices than others. But so far, it’s clear that corporate America has, on average, been managing the inflation squeeze fairly well. You can see this in companies’ gross margins—the difference between the price at which a company sells its products and what it costs to make them.
What do we see in public companies’ gross margins? Among the companies in the S&P 500, gross margins have improved, on average, by 0.6% this year. For comparison, gross margins increased by 0.2% between 2018 and 2019—the most recent normal, pre-pandemic years. In other words, companies have so far done a fine job passing along price increases to customers and thus maintaining their profits.
Gross margins are one measure of corporate profits. Another measure—and the one that matters most to investors—is earnings per share. The results on that score have been similarly positive. In total, S&P 500 companies’ earnings are projected to grow by 8% this year. In 2023, earnings are projected to notch another 8% or 9% increase.
Because share prices ultimately track corporate earnings, these numbers are clear evidence, in my view, that stocks offer solid protection against inflation. You might, however, dismiss this as an academic exercise. After all, stocks are down this year even though profits are up. There’s no denying that, but there’s an explanation—one that, in my opinion, should help investors maintain their faith in stocks.
As noted earlier, stock prices generally follow corporate profits, but they don’t move in lockstep. Here’s how I’d think about it: Imagine two people driving to the same destination but taking different routes. They’ll diverge along the way. But in the end, they should converge upon the same place. That’s how I look at the stock market. Divergence is what we’ve seen this year. Corporate profits are positive, but the market is negative. Convergence will happen down the road.
There’s a ratio to measure the relationship between stock prices and corporate profits. You’re probably familiar with it: It’s the price-earnings, or P/E, ratio. This is a useful measure because it helps explain what we’re seeing in the market this year.
At the start of 2022, the P/E on the S&P 500 stood at 23. But as share prices have tumbled even as earnings have climbed, it’s fallen to just 17 today. That’s a roughly 25% decline. In industry terms, this is called multiple compression. It’s what typically occurs in periods of increased investor anxiety. But there’s no reason to believe this will be permanent. When today’s dark clouds give way to clearer skies, it’s reasonable to expect the market’s P/E to expand again. When that happens, we’ll see the opposite of what we’ve seen this year: Stock prices will rise disproportionately faster than earnings.
When will that happen? I can’t put a date on it, but it’s easy to see what might make that a reality: anything that helps allay investors’ present concerns—a resolution to the war in Ukraine, for example. When positive developments like this arrive, stock market investors will likely be rewarded. In the meantime, I wouldn’t worry about this year’s difficult environment.
I also wouldn’t worry if things get worse before they get better. In recent public statements, the Federal Reserve indicated its intention to continue raising rates, even at the risk of pushing the economy into recession. That very well could happen. Indeed, some observers believe the economy is already technically in recession. Still, I wouldn’t let that hurt your confidence in the stock market as a reliable tool for building wealth and protecting against inflation over time. Remember: The stock market never moves in a straight line. But historically, over the long term, it’s always taken patient investors where they’ve wanted to go.