As most of us in the West will take time out at the end of the year, I want to invite you to reflect on your investments and what next year and the years after will bring. In particular, I want you to consider all the ways you could go wrong.
Over the past few weeks and into early January, I’ve been going through this process professionally, as I write my big annual outlook for 2022. And one of the things I struggle with is inflation. I remain in the camp of those who believe that current inflation—energy price inflation, in particular—will be transitory and will subside once demand for energy drops in the spring. I’m not as optimistic about inflation as the US Federal Reserve: I expect it to be above the Fed’s forecast, but I still think inflation will come down next year and beyond. of the.
But what if this is not the case?
One thing I have to do is consider what happens if inflation is not transient. What if energy shortages and supply chain disruptions persist through 2022? What if higher energy prices translate into higher real wages and there is a wage-price spiral like the one we saw in the 1970s? How would this affect my portfolio and how would I change my investments if this were to happen?
Inflation in the United States, 1971 to 2021
And then, once I’ve thought about all that, I do something else. I’m thinking about why the scenario I think won’t happen shouldn’t happen. This is where it gets difficult. Our natural impulse is to simply dismiss potential developments that contradict our preconceived notions without too much scrutiny. Our instinct is to wave and assume that things have always returned to some sort of normality after an abnormal period. In a sense, I think inflation will return to a pre-pandemic normal, while those who expect inflation to spiral out of control are anticipating a normal reminiscent of the 1970s and 1980s.
But remember: There is no law of gravity in finance. A constant theme throughout my last three years of finance writing has been how the world has changed significantly since the global financial crisis (GFC). Things don’t work like they did in the 1980s or 1990s, let alone the 1970s.
So I have to force myself to explain how things are going to play out and back it up with data, not anecdotes. And I challenge you to do the same with your opinions and expectations. Don’t make your point with anecdotes or fall into other rhetorical traps, slippery slope arguments, etc. “If we allow this to happen and don’t fight inflation now, it will take root and spiral out of control.” You will lose credibility in my eyes and I will classify your opinions in the drawer entitled “Ideologue”.
My rule of thumb is to only reject a result if you can show beyond a reasonable doubt why it can’t happen. If you can’t do that, consider the possibility that you were wrong and what that could mean for your investments.
Now many of you are smiling. For what? Because my view that inflation will be transitory is the one most rejected by investors these days. Contrary to economists, the consensus among professional investors seems to be that the inflation picture will worsen next year.
Cyclically-adjusted PE ratio (CAPE) in the United States
But here’s something to ponder: If you’re confident that inflation — and interest rates — will reverse a decades-old trend and begin a protracted recovery, you must also believe that stock markets are significantly overvalued. Hundreds of charts, especially the Cyclically Adjusted PE (CAPE) ratio popularized by Robert Shiller, show how the US stock market soared into overvalued territory a long time ago.
So many investors have sounded the alarm: current valuations are unsustainable and need to come down. It’s been their refrain for more than a decade. And they’ve been wrong for over a decade.
So my question on falling US valuations is: what if not?
To learn more about Joachim Klement, CFA, do not miss Risk profiling and tolerance And 7 mistakes every investor makes (and how to avoid them) and sign up for his regular comments on Klement on investment.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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