As the Dow reached new heights over the last few weeks, we have heard many outlooks on how it's going to come to an abrupt halt. Sell in May go away is around the corner, Cyprus uncertainty sending negative reverberations, quantitative easing creating hyper-inflation and many more. But as consumers, we must pay attention to the multi-versed views of economists around the country. Admired professor Jeremy Siegel recently proposed his view on the current market conditions. He believes in the concept of multiple expansions, 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. So who is the biggest threat to the current market rally? Ben Bernanke.
The Federal Reserve Chairman has consistently stated that the cost of the quantitative easing program is unknown. Essentially, he's saying that excessive money printing can create a high inflation environment, but he doesn't want to admit it. 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. Multiple expansion only occurs during periods of stable prices. The following chart depicts the S&P 500 P/E ratio and the year-over-year 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 decorative language - multiple compression. The key level to watch is roughly a 4% year-over-year 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 is the single 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 attentive for the catalysts that could reverse the current paradigm. 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, it is critical for investors to pay attention to these fundamental indicators.