Inflation fears loom large. The Federal Reserve Board’s aggressive stance seems driven by its own panic about not having reacted sooner. This isn’t the first time the market has been worried about a return to 1970s inflation. The cover of The Economist in June 2004 (when the Consumer Price Index (CPI) was just 3.3%) titled Back to the 1970s? is a prime example of how periods of above-trend inflation tend to be compared to the decade that saw inflation reach levels not seen since the 1940s. Obviously we did not see a return to the 70s then. Is this time different? With inflation break-evens, commodities, and freight rates substantially off their highs, the markets clearly believe we’ve seen peak inflation. Given tight labor markets and the ongoing conflict in Ukraine, we can’t rule out an extended period of inflation higher than past couple decades. What can we learn from the 1970s that might help us today?
Our research leads to two main insights:
- Patience is often rewarded. History suggests that when inflation has been as extreme as the June CPI reading of 9.1%1, forward one-, three-, and five-year S&P 500 returns from the peak are not only very attractive at +37.2%, +16.4%, and +18.6%, respectively, but positive 100% of the time! Moreover, the three- and five-year returns in each of these instances coincided with a recession at some point. Investors can be rewarded by remaining fully invested through the uncertainty.
- Low valuation can provide a significant amount of protection during inflationary periods. All six sectors with below market Price-to-Earnings (PE) multiples going into the 1970s outperformed the S&P 500 by an average of 400basis points (bps) while the highest-yielding 30% of stocks on both an earnings and cash flow basis outperformed their more expensive counterparts by roughly 2x!2 Counterintuitively, the highest quality companies, which price in a low interest rate environment, could present heightened risk if interest rates continue to rise.
Consumer Discretionary has historically struggled during recessions caused by monetary tightening. In this context, the market’s knee jerk reaction to punish Consumer Discretionary makes sense. We believe the current supply/demand dynamics in certain areas of Consumer Discretionary are vastly different than what we saw in the 1970s. For example, in the illustration below, the current undersupply in the Auto sector relative to demand suggests a shallower trough this cycle. The 25% drop in US seasonally adjusted auto sales (SAAR) during the 1973-1974 recession implies trough sales of 13M units, matching the SAAR print over the trailing three-months! We are already at or near trough sales! Given the semiconductor shortage is limiting current production capacity, we believe the skew from here is to the upside. We again believe patience will be rewarded as autos led the rebound coming out of the 1973-1974 recession, outperforming the market by over 3,000bps!
History suggests the current 25% drawdown could be close to a bottom while not remaining fully invested is costly. Of the five major inflation peaks since the 1940s, two did not result in a bear market while the three that did saw a median drawdown of ~30%. The Fed-induced recession of 1980, which ultimately broke secular inflation and often draws parallels to today, saw an ensuing bear market decline of just 27.1%. And while the current market PE multiple of 17.8x at face value is elevated relative to the 7x multiple in the early ‘80s, it’s not when considering the 10-year treasury yield was at ~14%. In fact, the average spread between the S&P 500 earnings yield and 10-year treasury since 1962 implies the market multiple is currently pricing in a move in the 10-year treasury yield to 5.0%, presenting potential upside if that does not occur. Following the bottom in 1982, it took just three months to reach new highs while remaining fully invested yielded a five-year forward annualized market return of +26.6%. Not being fully invested at the bottom was an expensive mistake, costing you 440bps and 760bps per year if missing the first one- or three-month periods, respectively, off the bottom.
Hindsight is 20/20. Like the 1970s, the current environment began with a burst of a growth bubble and involved a commodity spike due to geopolitical shocks. That said, more muted demographic trends and inflation expectations suggest this episode could be more transitory. Only time will tell. While no one has privileged access to the future, understanding history can help inform our portfolio positioning and reinforces our focus on being patient, flexible, and long-term focused.
If you would like additional details on our analysis, please reach out to MacKenzie Bozel.
Tyler Grason, CFA
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1Peak inflation above 9.1% has occurred five times since the 1940s.
2The portfolios for July of year t to June of t+1 include all NYSE, AMEX, and NASDAQ stocks.
Investment Risks: All investments are subject to risk, including possible loss of principal.
The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2022 Miller Value Partners, LLC
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