On Friday, venerable professor Jeremy Siegel was on the Halftime Report to express his view that the stock market was poised to reach record highs. His view is based on the concept of multiple expansion, which is a fancy way to say that investors will pay more for a dollar's worth of earnings. The Great Reflation experiment currently being conducted by the world's central banks have left investors with few options to generate returns. This reality of limited options makes Chairman Bernanke's speech on January 14th the biggest threat to the stock market rally.
The Chairman has consistently stated that the cost of unconventional policy is unknown - which is a fancy way to say excessive money printing can create a high inflation environment. The threat that inflation could run hotter than desired is a primary concern for equity investors. Contrary to popular belief, stocks do not outperform during periods of high inflation. What's more, multiple expansion only occurs during periods of stable prices. The following chart depicts the S&P 500 P/E ratio and the yoy percentage change in CPI.
Source: BLS and Bloomberg
It is clear to see that as inflation rises, the P/E ratio actually falls - or in fancy language - multiple compression. The key level to watch is roughly a 4% yoy change on CPI - it is at these levels that investors are no longer willing to pay more for a dollar of earnings. There are two possible explanations for this behavior: 1) investors begin to anticipate central bank tightening and/or 2) investors use the higher expected rate of inflation to discount future earnings, thus reducing the present value of those earnings. Regardless of the explanation, the fact remains that rates of inflation above 4% tend to lead to a lower P/E ratio - and this is where Chairman Bernanke comes in.
With the most recent Fed minutes making investors think twice about the duration of quantitative easing, Bernanke's speech on January 14th poses the biggest threat to the stock market rally. Chairman Bernanke has a tiny needle to thread - he must convince investors that quantitative easing will create just enough inflation to make multiples expand while also guarding against the inflationary consequences of hyper-expansionary monetary policy. The margin for error is slim.
As investors we must constantly be vigilant for the catalysts that could reverse the current paradigm - Chairman Bernanke's speech is just such an event. Luckily, the actions of the Federal Reserve have suppressed volatility providing investors an opportunity to buy low cost insurance. The CBOE Volatility Index (VIX) is approaching historic lows which means put options are cheap. While Bernanke poses the biggest threat to the stock market, investors need not suffer. Buy puts.
Disclosure: Shelter Harbor Capital is long SPY puts
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.