This is why inflation is painting a dark picture for the stock market outlook

Published Tue, Apr 26 20221:11 PM EDT

Runaway inflation is not only making life tougher on consumers paying high prices for virtually everything nowadays, it also is making stocks less attractive. In normal times, stocks can be an attractive investment as inflation rises. Companies receive higher prices for their goods, boosting profit margins. Price to earnings multiples historically have fallen, making stocks a good place for bargain hunters. But in the current case, even with rising interest rates and inflation running at its highest pace in more than 40 years , multiples have moved little. The S & P 500 is still trading around 19 times forward earnings, making stocks look relatively expensive. Looking through the prism of the S & P 500's dividend yield against the rate of inflation, the story does not appear to be a good one for equities. "The implication is that adjusted for inflation, the earnings yield on stocks has never been lower," Lisa Shalett, Morgan Stanley's chief investment officer of wealth management, said in a note Monday. "This situation has contributed to the collapse in the equity risk premium." The S & P 500's dividend yield, or the amount it pays out per share vs. its price, is parked around 1.4%. With core inflation running at 6.5% and the headline number at 8.5%, that puts the divided yield in deeply negative territory. Yardeni Research computes the current real earnings yield at 6.63%, a depth not seen since the early 1980s, which also was the last time inflation ran this high . Doubts over the 'TINA' argument The same has been true for the equity risk premium, or the amount of excess return over safe-haven investments. Falling premiums make risk less enticing as investors can simply park money in cash or equivalents without all the risk. The equity risk premium is largely theoretical, but Morgan Stanley calculates it now to be around 220 basis points, or 2.2 percentage points, which is well below the long-run average of 350 basis points. Shalett noted that the market has held up fairly well over the past month despite the inflation and valuation issues. Stocks were down sharply Tuesday after a whipsaw rebound Monday that ended with the market higher. "Equity investors seem to believe at least one of three things: Inflation will be short-lived; earnings will prove more resilient than expected; and global investor flows will still come to the US because it's the best equity market," she said. Morgan Stanley, though, "sees these assumptions as magical thinking," added Shalett, who addressed the "TINA" theory that "there is no alternative" to U.S. stocks at a time when inflation is running high around the world. "Such relative optimism around US stocks seems based on a belief in that inflation will subside, corporate earnings will remain robust and that US stocks are the best alternative in global portfolios," she said. Morgan Stanley's investment committee "is less convinced, believing that risks around real rates, valuations, earnings, market liquidity, inflation and most recently, the strong US dollar, are worth discounting." Hope from the '80s One bull case is that while the current inflation picture looks something like the early 1980s and its stagflation, some investors see key differences. For instance, the '80's economy was staggering through a double-dip recession as rates were rising, while few Wall Street economists see the U.S. entering negative growth now. One big reason for the recession was the Federal Reserve jacking up interest rates in an effort to lower inflation. The increases then were far more severe than what is expected from the central bank this time around, though the prospects of higher rates are still scaring investors . Ross Mayfield, investment strategy analyst at Baird, noted that even in 1982 stocks managed to rally despite the recession. "Most importantly, the market persevered the 1982 environment, rallying into year-end and ultimately kicking off a multi-decade bull market that lasted until 2000," Mayfield wrote. "Even if we shorten the timeframe a bit, the market rally and economic strength continued after 1982 ended. One year is a small sample size, and given the complexity of the world, there are certainly differences to be aware of, but we believe history can ground us when the future is unclear."

Traders work on the floor of the New York Stock Exchange (NYSE) on April 25, 2022 in New York City.

Spencer Platt | Getty Images

Runaway inflation is not only making life tougher on consumers paying high prices for virtually everything nowadays, it also is making stocks less attractive.