Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:
In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.
For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.
The economy and stock market’s profitabilities do not always walk hand-in-hand. In 2020, for instance, to the surprise of many observers, we saw the former collapsing and the latter booming. Is it possible 2021 might see the opposite?
A protest movement in France named the “Gilets Jaunes” (Yellow Jackets) began in October 2018 due to a tax increase on fuel. The movement was populist, widespread, and spontaneous, and only weakened in 2020 due to coronavirus lockdowns.
Was 2.6 cents per liter extra tax on gasoline such a big deal?
The answer is yes. Inflation on a household’s constrained expenditure can unleash the “Gilets Jaunes multiple,” and kill consumption and stock markets.
The risk has now crossed the Atlantic.
Some forty years ago, Charles Gave introduced the “Four Quadrants” concept, used by generations of investors to drive asset allocation in global investment portfolios. The concept crosses inflation and growth to cluster four macroeconomic situations: inflationary boom, inflationary bust, disinflationary boom, and disinflationary bust.
Here we revisit the concept with a scientific eye, applied to ecosystems. We focus on the second derivative of economic production or asset prices, i.e. the acceleration or deceleration of growth and inflation, intentionally ignoring the levels of inflation and growth. A new “Four Quadrants” is born, bridging macroeconomy and simple mathematics. It massively amplifies Charles’ discovery decades ago.
What is it telling us? That the US game on equity price-earnings’ expansion is over.
Equity holders are brave investors who abandon their capital forever (unless they find a third party in the marketplace to replace them, which is never guaranteed) against a flow of uncertain future dividends. Companies, therefore, must distribute dividends, and they can only do so in two ways: they either pay dividends on capital if earnings are sufficient, or they pay dividends off capital.
The worse of the two is the latter and leads to capital destruction. So, who is responsible? The most influential macro factor on portfolio construction for long-term investors, today on the verge of resurfacing: inflation.