Stocks have impressed through the first eight months of 2021, gaining more than 21 percent through the end of August. The Real Estate sector has led the way higher, gaining 32.64 percent, followed closely by financials with a gain of slightly more than 31 percent and energy gaining nearly 31 percent. This may not come as a surprise considering the reported inflation numbers. The Consumer Price Index has bounced above 5 percent for the past two months, and Producer Price Index numbers, showing prices paid by companies for raw materials, are likewise high and rising, indicating we may see more price inflation in months to come as these companies pass those higher prices on to consumers. Energy, real estate and financials tend to perform well when consumer prices are on the rise.
Inflation remains a hot topic, and I believe it is unlikely to go away as quickly as the Federal Reserve and U.S. Treasury may think. Both have stated their belief that interest rates have been too low for too long. Several things have come together to make inflation our new reality. The recovery from COVID-19 has spiked consumer demand while the global supply chain was still suffering damage from lockdowns. Adding to that is the labor shortage that many blame on the government’s free money policies aimed at softening the economic blow suffered last year. Excess money has been known to cause prices to rise, but many consumers opted to save their stimulus, which may prove less inflationary in the long term, making it tough to tell what comes next for our economy and how to invest in anticipation of the next economic move.
We saw interest rates rise in the first few months of 2021, but they have begun fluttering slowly lower since May. Valuations seem very high as the market continues rising, adding to the complexity of market conditions. The average price-to-earnings ratio for the S&P Index stocks, remains well above its long-term average of about 17, recently measuring near 27, indicating the market is trading at a 53 percent premium to its average. However, recent earnings support the high prices as companies reported second-quarter results with revenue growth at 25 percent and earnings growth of 92 percent relative to the easy comparable of second quarter 2020. Furthermore, revenue measured 4.6 percent better than expected, while earnings blew away expected results by 16 percent. It’s hard to argue against stock prices rising when results are so good.
So now for the question, “What comes next?” With COVID-19 fears on the rise again and interest rates more likely to rise than fall, I believe investors should take measures to manage risks of falling stock prices. No, not selling to cash, but being more selective in portfolio allocation. I believe inflation stocks like banks and energy companies (the old out-of-favor petroleum kind) will continue to benefit investors, as will those with more attractive valuations like health care companies and consumer staples. Bonds are likely to continue their underperformance of inflation for a while, meaning short-term maturities are best until we see inflation subside, but they still provide protection from the volatility of stocks; therefore, bonds are appropriate for known spending needs within the next 10 years.