What common stock sectors do well in an inflationary environment? Energy, income-producing real estate, banks, homebuilders and others come to mind. Research from Fundstrat shows that despite the emergence of electric cars and hybrids, gasoline use by millennial Americans is expected to double in 10 years. If 90 million American adults use twice as much of a product and there are only 240 million adults in the U.S., you get the cocktail ingredient required in the classic definition of inflation.
Since they are not making more land and millennials now are spreading themselves across the country, we are reminded that real estate has been a very good inflation hedge historically. In fact, for most American families, homes have been their most successful source of net worth in retirement. It makes the homebuilders a good long-term bet despite their recent run up in price. Homes outperform stocks for most households, because of stock market failure.
Interest rates went up from 1965 to 1981. You’ll be shocked to hear that the banks raised lending rates faster than they raised their deposit rates. Now that Buffett has bailed on Wells Fargo (WFC) and JPMorgan (JPM), those of us who have owned the stocks since 2012 are having their faith in the stocks challenged. Banks outperformed in the early stages of the 1960s version of the inflation cocktail. We are patient, but that patience doesn’t last forever.
Lastly, value outperforms growth immensely when the inflation cocktail gets mixed. Price-to-earnings (P/E) ratios in the S&P 500 peaked in late 1972 at 18x P/E and bottomed in 1981-1982 at 6x P/E. This was a 66% contraction in P/E multiples. What could this inflation cocktail do to the Russell 1000 Growth Index, which is starting at 40x P/E? Or the S&P 500 Index, which is starting at 24x P/E? The chart below shows the 13-year pounding that the Russell 1000 Value Index took at the hands of the Russell 1000 Growth Index:
Growth stocks have gone up nearly five-fold while value stocks doubled. Despite that fact, value has outperformed growth by 3.5% compounded over the last 94 years as measured by Ibbotson and Associates. Since the inflation cocktail is closely related to value stock outperformance, we are very excited about our future value investing possibilities.
William Smead is chief investment officer at Smead Capital Management.