‘The Great Crash’ by John Kenneth Galbraith is the definitive account of the Wall Street crash of 1929. From the relative calm of 1954, Galbraith captured the frenzy of the soaring rise, the searing collapse and ultimately the stunned devastation of that dramatic Autumn. Toward the end of the book, in words that resonate strongly today, he chose to comment on whether another crash would come:

‘No one can doubt that the American people remain susceptible to the speculative mood – to the conviction that enterprise can be attended by unlimited rewards in which they, individually, were meant to share. A rising market can still bring the reality of riches. This, in turn, can draw more and more people to participate. The government preventatives and controls are ready. In the hands of a determined government their efficacy cannot be doubted. There are, however, a hundred reasons why government will determine not to use them.’

Stock investors have enjoyed remarkable returns in recent times. From a low of 666 in March 2009, the widely followed S&P 500 Index of US stocks recently broke 4,200. Arguably more remarkably, the index is now up over 80% from the pandemic panic low on the 23rd of March last year.

S & P 500 – Daily Chart

While many reasons are cited for this remarkable rally, the persistently low level of interest rates, bond yields and therefore discount rates have been a consistently strong tail wind. After all, the choice of a discount rate is an unavoidable decision in the valuing of any asset, and everything else being equal, the lower the rate the higher the asset value and vice versa.

A key ingredient in the calculation of an ‘appropriate’ discount rate is the rate on offer from a broadly ‘risk free’ alternative such as a 10-year government bond. Again, everything else being equal, the lower the yield the higher the asset value and vice versa.

Clearly, the policy choices since the global financial and then global pandemic crises of extraordinarily low official interest rates and quantitative easing have been important. But ultimately, this era of historically low interest rates and bond yields is underpinned by consistently low inflation, and inflationary expectations.

US inflation surged to a 13-year high last month with consumer prices 5% higher than a year ago. In the Eurozone meanwhile, annual inflation rose to the ECB target of 2% for the first time since late 2018. But for now, investor confidence that low inflation is securely anchored remains strong.

Inflation Expectations Rise – But Still Moderate

While this confidence may continue to prove well founded, its current strength suggests the risk of disappointment represents an increasingly asymmetric risk for investors. Although many stocks remain attractively priced relative to competing investment choices such as government bonds or bank deposits, any jolt to the consensus of securely anchored inflation would likely have a significant impact on style preferences within the stock-market.

More particularly, the highly valued, growth-oriented names which have been increasing beneficiaries of low rates would likely suffer relative to their less expensive, largely out-of-favour counterparts.

As bond yields and consequently discount rates have plummeted, high multiple stocks – whose value lie disproportionately in the future – have benefitted accordingly. In bond parlance, they are the long-duration segment of the stock-market and are now the most exposed to any inflationary surprise.

The Dominance of the FAANG’S

More generally, there are many seasoned investors greatly concerned about the environment of recent years. They may not dispute the attraction of stocks relative to bonds or deposits, but they have grave concerns about the extraordinary landscape since the global financial crisis.

In this regard, the words of legendary investor Seth Klarman of Baupost are particularly apt:

‘Investing today may well be harder than it has been at any time in our three decades of existence, not because markets are falling but because they are rising; not because governments have failed to act but because they chronically overreact; not because we lack acumen or analytical tools, but because the range of possible outcomes remains enormously wide; and not because there are no opportunities, but because the underpinnings of our economy and financial system are so precarious that the unabating risks of collapse dwarf all other factors.’

Of course, it is impossible to know if such concerns are warranted, or when the mood of the market might darken to reflect them. The outlook is never clear-cut.

While investing in a portfolio of sensibly diversified and conservatively valued companies continues to look attractive, it seems timely to note the possibility that the current consensus about the inflation outlook may prove complacent. Even if the words of Galbraith and the concerns of Klarman prove misplaced, the risk of a significant change in style preferences within the stock-market is mispriced.