This chart on inflation’s impact on stock prices is truly scary

Investors should be hoping fervently for inflation pressure to subsidize because market history says sustained price increases means stock prices are going lower. A lot lower.

BofA Securities US quantitative strategist Savita Subramanian’s quarterly S&P 500 Relative Value Cheat Sheet was released this week and included a section titled Four Scary Charts. Three of them – two of which highlighted profits at highs relative to cyclically normalized levels, and another showing that energy stocks were still under-owned and causing career risk for underweight portfolio managers – didn’t worry me all that much.

The chart showing price to earnings (PE) relative to inflation growth was another case entirely. Using PE ratios and the US consumer price index data since 1965, Ms. Subramanian estimated that the current S&P 500 PE ratio is 70 per cent higher than history says it should be. (I posted the relevant chart on social media here).

Inflationary and stagflationary environments – the latter of which is characterized by rising prices along with slowing economic growth – are terrible for most equity market sectors. Stated simply, rising input costs cause manufacturers to raise prices, and consumers demand higher wages to compensate. Higher wage costs join the higher input costs to limit profits. If wage growth lags goods inflation, consumption declines, reducing corporate revenues.

In inflationary periods, companies are struggling to grow or even maintain earnings while bond yields rise. Investor assets flow towards the solid compound annual returns of risk-free bonds (for buy and hold investors) and away from equities. PE ratios decline as bond yields attract more investors from equities.

Thankfully, the strategist sees the PE ratio/inflation correlation as only one piece of the puzzle and is not predicting a 70 per cent decline for the S&P 500. Ms. Subramanian sees flat markets until the end of the year with strong cash flow and stock price appreciation in the energy sector offset by falling profit expectations in consumer spending-related stocks.

In addition to the energy sector, BofA is recommending US health-care stocks. For one, the strategist finds sector valuations attractive in terms of free cash flow relative to enterprise value, a measure of a company’s total value by adding debt and cash to its market capitalization.

The pharmaceutical subsector is “recession-proof,” in her words, and biotechnology companies provide secular rather than cyclical growth.

Perhaps most importantly, pharma and biotech stocks “trade at record discounts to other defensive sectors,” Ms. Subramanian notes. “Pharma is 40 per cent cheaper than [consumer] staples and … Biotech trades at a 50 per cent discount to Info Tech.”

BofA does not expect massive profit margin compression and a deep equity market decline in the near term. However, the longer inflation pressures continue, the more likely a painful correction becomes.

— Scott Barlow, Globe and Mail market strategist

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The Rundown

How the resurgence of unions could hurt your stock portfolio

Workers are on the market. Amazon.com Inc. workers in New York voted last week to join a union, the first at one of the company’s US facilities. Meanwhile, Starbucks Corp. is grappling with a wave of union organizing that began last year with a location in Victoria and has since spread to several of its US locations. And they aren’t the only cases where unionization is spreading. As Ian McGugan tells us, investors may want to spend a few minutes pondering what a stronger labor movement would mean for the companies in their portfolios.

Guns and power: Positioning for new era in European stocks

A month of the war in Ukraine briefly erased a year’s worth of gains for European equities but the continent’s scholarships have quickly recovered as investors have poured money into sectors such as energy and defense which are poised to benefit from one of the deepest policy shifts in the region in decades.

Also see: Russia’s ruble rebound not quite what it seems

Others (for subscribers)

The highest-yielding stocks on the TSX, plus risk data

Friday’s analyst upgrades and downgrades

Thursday’s analyst upgrades and downgrades

Friday’s Insider Report: CFO is a buyer of this REIT yielding 6.4%

Thursday’s Insider Report: Director invests $2-million in this high-yielding stock that’s had consistent dividend hikes

Number Cruncher: These 15 Canadian dividend stocks should appeal to conservative investors

Number Cruncher: Ten US-listed large cap stocks with a history of dividend growth

Globe Advisor

Investors seeking inflation hedge snap up US farmland

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Ask Globe Investor

Question: My question might be a bit ‘101-ish’ but it’s something that I’ve never seen answered (or maybe asked).

When I contribute money to my RRSP and then invest in dividend-paying and DRIP-able stocks, do I have to keep track of capital gains, interest payouts, new shares acquired, etc. for each stock? And what if I choose to sell some/all the shares of a stock and purchase other shares with the gains, while keeping everything in the RRSP. Do I need to keep track of this too?

Or does it not matter how much or little I’ve gained/lost on each of the stocks within my RRSP? Because what is ultimately being taxed is the amount I withdraw in a tax year (deemed to be ‘income’ by the CRA) regardless of how my portfolio of stocks grew or what investment actions were taken.

Whew that was long-winded! But it’s been a question 20 years in the making! – Doug W.

Answer: You can exhale. All transactions within the RRSP are tax sheltered. No record keeping is required. As you say, for tax purposes the CRA is only interested in how much comes out of the plan, not how it got there.

–Gordon Pape (Send me questions at gpape@rogers.com and write Globe Question in the subject line)

What’s up in the days ahead

US homebuilder stocks are down – a lot. David Berman explains why every investor should care. More Brenda Bouw finds out what portfolio manager Dan Goodman is up to.

Rising rates, the high cost of war and other world market themes for the week ahead

Click here to see the Globe Investor earnings and economic news calendar.

We want to hear from you

Are you interested in being interviewed about your first stock purchase? Globe Investor is looking for Canadians to discuss their experience as part of this new, ongoing feature. If you’d like to be interviewed, please write to: jcowan@globeandmail.com with “My First Stock” in the subject line and include a short description of your first stock purchase.

Compiled by Globe Investor Staff

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