Copyright © 2021. Inderes Oyj. All rights reserved.

Fiery inflation data scorches stocks

What's up with Stonks is a biweekly report that delves into the complex and often confusing world of the stonk market. Community Manager Verneri Pulkkinen helps you navigate the troubled waters of market movements and macroeconomic phenomena. Stay tuned for the hottest investment scene news, moderate amount of stock populism and understandable information about the stock market.

Stock markets have been beaten with a telescopic baton as inflation remains stubbornly in place. This is logical, because rapid inflation isn’t that nice for equities and gives rise to massive interest rate hikes. The risk that something will break somewhere increases as financial conditions tighten.

In this post, let's discuss inflation data and briefly how investors are avoiding European stocks like the plague. The valuation of European stocks doesn’t look impossibly high. Just putting it out there for any contrarian investors among my readers.  

Fiery inflation data published

Tuesday's inflation data from the US burned like a three-chili dish from a Chinese restaurant. One starts to wonder when the plate is going be finished. Headline inflation is falling, thanks to lower fuel prices.

Instead, core inflation, which is specifically monitored by the Fed, is getting worse (more volatile food and energy prices have been wiped out of core inflation). Prices of housing, services, cars and other elements are rising rapidly. In this graph, annual inflation is broken down and the blue bar is services.

Consumers clearly still have too much purchasing power relative to the carrying capacity of the economy, which translates into higher prices.

From this Bloomberg graph, you can clearly see how a large part of the inflation basket is rising at an annual rate of more than 4%. It’s still around 60%, which indicates the inflation being present on a broad front.

This graph features several different measures of sticky inflation. I won't go into every one of them in detail. However, this graph underlines the point that no matter how you measure it, prices are rising at an embarrassingly persistent and widespread rate. We’ll have to wait for the realization of the deflationary hype of the latest post a while longer.

Some readers might wonder why I am so keen to raise the issue of even the slightest signs of inflation easing, when so far, the Inflation Monster has feasted on all the budding green on the ground. I discussed the impact of inflation on stocks in an earlier post. It's worth a look if you haven't read it already.

The more core inflation intensifies, the greater the task of eradicating it. Interest rate hike expectations bounced back up a notch in the market. Now the expectation is that the Fed funds rate will be pushed to 4.25% by next spring. The value of future cash flows of listed companies literally melts in your eyes.

Inflation can certainly be brought down, that's not really the problem. Interest rates can be raised and central bank balance sheets deteriorated until the economy is hardly breathing. The problem is that high inflation requires such a strong interest rate medicine that the patient — the economy — really loses consciousness in the process. A recession, i.e., a sharp decline in the economic pie from which companies are ripping off their profits, is not a good scenario for stocks either. Well, it isn’t for virtually anyone. But it's a price that must be paid to reverse inflation.

Stock markets tend to rally when inflation falls. This graph features the year-on-year change in S&P 500 and inflation rate peaks. As you can see, inflationary peaks have often been followed by a juicy run in the stock market. Therefore, investors are so keen to sniff out a turnaround, even though so far, the aroma hasn't been very pleasing. The turnaround may have been in June in the US, after which inflation has fallen a little and equities have risen, but it is too early to say.

Investors hate Europe

Optimism about Europe waned a century ago, after Oswald Spengler's The Decline of the West. Do not read this book if you get it in your hands for any reason. European pessimism is summed up in slow economic growth and the euro area's rickety debt problems. The latest nail in the coffin of the world's outdoor museum is the energy crisis, which is likely to push the Eurozone into some kind of recession, the depth of which is still a mystery.

According to the Global Portfolio Manager Survey, professional investors underweight equities, especially European equities. European technology stocks are one of the most hated asset classes in the world today. If you're wondering why many of the investment community's favorite stocks have taken a beating this year, part of the reason is probably international investors flying the scene. Of course, there is nothing wrong with running away in itself, as the growth prospects of many growth stocks such as Harvia have deteriorated compared to investors' previous visions of galaxy-wide sauna empires.

Short sellers of equities, the rogues who profit from a fall in share prices, have set their sights on European equities. On average, just under 8% of all European stocks are shorted, compared with around 3% in North America.

The valuation of European equities doesn’t make you dizzy. The forward-looking P/E ratio is over 11x for the STOXX Europe 600 index. I wouldn’t take earnings forecasts in this environment without with a grain of salt. Forecasts are often made as if the world is moving forward linearly and there hasn’t necessarily been much attempt to model the effects of the energy crisis. After all, results are now expected to skyrocket in the near future.

Another way to look at the shares is to look at their book value. STOXX Europe 600, like Nasdaq Helsinki, trades at about 1.8 times its book value. However, the book value can be a problematic metric. For example, software companies have little more than a couple of computers on their balance sheet, maybe some goodwill from acquisitions and a net cash position, unless they capitalize R&D costs and user acquisition, which they almost never do. “Fortunately" in Europe, companies that utilize their balance sheets dominate the stock markets. For example, banks, industrial and energy companies are capital-rich sectors.

This graph compares the P/B ratio of the S&P 500 to Europe. The more tech-oriented US stock market is valued twice as high in terms of P/B. Behind this is of course the fact that American companies get a much better return on their capital and have a better growth outlook.

Return on capital and growth drive the value of shares, so the valuation difference is often justified. Now the gap has widened significantly.

The return on equity for European equities has averaged 11% over the last 20 years, which is what I was able to extract from the data I pulled from Bloomberg.

Let's have a tiny math exercise. If the return on equity were normally 11% and the shares were paid 1.8 times their equity, the normalized P/E ratio would be over 16x. In reality, the present value of listed companies should be derived from future cash flows, but let's have a little fun and talk about these barbaric multiples. The figures for Nasdaq Helsinki are roughly on the same ballpark, so this exercise can be generalized to the big companies on the Finnish stock exchange.

Over 16 times normalized earnings per European share translates into an earnings yield of over 6%, while the long-term earnings outlook is weak. If earnings growth stalls, that 6% earnings yield isn’t flattering, as the average nominal return required on equities is perhaps 7-10%.

Dividend yield on European shares is about 3.6%. In turn, now that we're cutting corners this means that 40% of the profits are invested in growth (60 % are paid out as dividends). With return on capital of 11%, that translates into a profit growth of about 4.4% over time. And that is with a bold assumption that the return on incremental invested capital will match previous levels.

In other words, at this price, the investor gets a dividend yield of just under 4% and 4% earnings growth, so the total return would be around 8% if the multiples remain stable. That is, if stocks marched upwards in line with earnings growth. Doesn't feel extremely bad at the index level, though not very good either. However, it's pretty close to the required rate of return on capital. This was a very rough way of calculating.

In reality, European stocks are expected to have a higher return on equity and earnings growth, but I decided to calculate these conservatively. If an investor believes that listed companies have a return on equity of 13% and faster earnings growth, the stock market is very favorably priced. Contrarian investors, are you out there?

Below the surface of the index, there are stocks that have already come down by more than 70% on the Finnish stock market. I don’t think that companies like Kamux and Harvia are really such bad companies if an investor can only look a couple of years ahead. Of course, we shouldn’t naively assume that the good days ahead will be like the previous ones. You'd think that there would already be something for a stock picker. The small company index, which is a good indicator of the performance of Finnish smaller firms, has already collapsed by 35% from its peak.

If you are the kind of investor who only wants to buy when the stock market is crashing and the stock market is cheap at the index level, now is not the time yet. In any case, the flight of investors from Europe may bring opportunities for local fishing waters.

Thank you for reading the post! Read analysis and make good stock picks!

Verneri Pulkkinen