US Stock Market at Risk of P/E Deflation

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Crescat Capital’s commentary for the month ended June 2021, discussing that the US stock market is at risk of P/E deflation.

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Dear Investors:

The US stock market is 51% overvalued and at risk of a 34% decline. The catalyst is inflation which has arrived in spades and is likely to stay for a while. We think shrewd investors should be getting positioned now for the Great Rotation to both protect against and profit from this critical macro shift. Inflation is likely to be one of the defining characteristics of this decade, and anything but short-term, as the Fed’s recent spate of “transitory” bluster would have trusting souls believe. An enduring trend of rising wholesale and consumer prices is likely to topple today’s stock market by deflating its historically high price-to-earnings ratio. For proof that inflation deflates P/E multiples, look at the strong relationship between CPI and the earnings yield (inverse of P/E) of the S&P 500 Index over the last seven decades of data in the chart below.

Most importantly, note the high near-term risk to the S&P 500 posed by the sharpness of today’s upward inflationary divergence. While the stock market can be a good hedge against inflation over the long term, keep in mind that in overvalued markets, rising inflation can be a killer. As we have shown in prior research letters, the stock market is as expensive as it was at major market tops in 1929 and 2000 and is just as speculatively over-owned and overbought. Combine all the above with bearishly diverging market internals as flagged by deteriorating market breadth, and we have a panoply of ingredients that should be a blaring siren of a probable market downturn ahead.

S&P 500 Price Target: 2,903

At the current inflation rate of 5%, the target earnings yield for the S&P 500 is 6.6% based on the historical regression of earnings yield and CPI. This equates to a P/E of 15.2, far from its 3.3% earnings yield and 30.3 P/E today. To arrive at our S&P 500 destination price, apply the target 15.2 multiple to Wall Street analysts’ current calendar year 2021 EPS estimates of $191, and voilà, Crescat’s current valuation-based target for the S&P 500 is 2,903. This compares to today’s all-time high price of 4,370 for the same index. This is not sensationalism, but macro realism based on history, economic data, current fundamentals, and math. Keep in mind that it is a moving target based on these same factors.

Analysts Underestimating Rising Wage Pressure

We believe that we are being generous in using Wall Street analysts’ aggregate expected S&P 500 EPS of $191 as this would indeed be a new high for US large cap companies. Such earnings are not yet in the bag and could disappoint. Analysts are bullish on the prospects for the Covid-19 stimulus-led recovery translating into record earnings. We are concerned that these expectations are too high because analysts do not appear to be factoring in rising inflation’s likely squeeze on corporate profit margins. In the coming months and quarters, businesses are not only likely to continue to face rising costs of intermediate goods and services, but also rising wage pressures. We are particularly concerned about the underappreciated outlook for rising labor costs, a non-transitory inflationary force that, in our analysis, is only getting ready to take off.

Rent Affordability at Historic Extreme

US rent affordability is the worst it has ever been relative to wages. Similar near-record imbalances are evident with respect to housing prices. Worker remuneration is much more likely to rise (than rents or house prices fall) to cure this imbalance due to acute labor shortages.

US stock market

Tight Labor Market

When it comes to macro indicators of a tight labor market, the ratio of job openings vs. new hires is at a record high. Even with waning government handouts post pandemic, wages will likely need to increase to incentivize people to go to work.

US stock market

Other macro diffusion indices, such as the NFIB Small Business Job Openings Hard to Fill and Conference Board Jobs Plentiful vs. Jobs Hard to Get also show levels of historic labor imbalances that signal a coming jump in wage inflation.

Wage-Price Spiral

Ultimately, it is the economic phenomenon known as the “wage-price spiral” a reflexive loop that can keep inflation surprising to the upside for years that makes true inflationary cycles anything but short-lived. Investors will need to look to the decade of the 1970s for guidance. Such economic reality has been deemed irrelevant by the investing behemoths that dominate the markets today. Too many investors have capitulated to the four-decade disinflationary trend and the over-used narrative that has come along with it based on advances in technology, globalization, and an aging population. Congratulations to those who have profited from it by staying long and strong in stocks and bonds, particularly in the S&P 500 Index and the large cap growth and mega cap tech stocks that dominate it today. In our analysis, the disinflationary trend is unsustainable, has been way overdone, and is at major risk of reversing under a new regime that we call the Great Rotation. The catalyst for this regime is rising inflation combined with investors looking out for their best interests in typical fear and greed fashion. We believe investors should get positioned ahead of what we view as a highly probable if not inevitable stampede.

An Inflationary Agenda

Our government is incentivized to underreport systemic inflation so that they can collect extra tax revenues on nominal growth while also containing inflation-indexed expenses. The Fed is a branch of government that supports it in these goals. Inflation also helps reconcile historic debt-to-GDP burdens by boosting nominal instead of real GDP. But investors must figure these things out for themselves. They should not blindly trust Fedspeak or the conflicted mainstream financial media with its incessant parade of stock and bond market apologists. These pundits can sound so smart and authoritative at times, but they do not always necessarily have an agenda that aligns with investors’ best interests. The Fed will not tell you that inflation is likely to be a problem, because then it is more likely to get completely out of its control. Similarly, your broker or financial advisor will not tell you that the stock or bond market is overvalued, because then you are more likely to close your account. Meanwhile, the financial media must keep their money management customers happy, so you are not likely to hear the bear case from them too often.

It is not always easy, but good investors need to be able to cut through the smokescreen and discern some things for themselves. The truth is that a lot of what has worked investment-wise in favor of stocks and bonds over the disinflationary last four decades is not likely to work in this decade.

The Great Rotation

We believe forward-thinking investors will increasingly be selling historically expensive stocks and fixed income securities and buying true inflation-hedge assets, including commodities in scarce supply and high demand, and stocks in a narrow group of sectors such as energy and materials that offer both low valuation and high cyclical near-term growth prospects. This is what we call the Great Rotation.

From a macro standpoint, in our analysis, the opportunity for our activist precious metals strategy has never been brighter. Inflation expectations are only beginning to take off. The Conference Board’s 1-year forward inflation expectation survey just hit 6.7% the highest since March 2011, a time when the leading junior gold mining ETF was 236% higher. As the chart below shows, it is still early in what is likely to be a rip-roaring bull market for gold and silver mining and especially our expertly crafted exploration-heavy portfolio.

US stock market

For those who would like some short exposure to the current at-risk over-valued stock market at large, in addition to our activist long gold portfolio, we encourage you to look at Crescat’s global macro and long/short hedge funds.

Performance Estimates for June


In June, we had a pullback in the Great Rotation trade after the Fed’s aggressive “inflation is transitory” campaign. In our view, it sets up an incredible entry point now for those who are not yet positioned in our strategies. Please note, our strategies were down substantially less than the Philadelphia Gold and Silver Index in June and have exceedingly outperformed that index year to date, as was the case in 2020. The precious metals benchmark was unbelievably down 13.8% last month. What a great buying opportunity.

With the drill season in full swing in Canada and Alaska, we expect a lot of positive news from our activist precious metals long holdings over the summer and fall. Our companies’ continued discovery progress should drive strong performance in the weeks and months ahead. We think we will be able to continue to deliver substantial alpha in our portfolio of companies that are making big high-grade discoveries at low valuations. What we are doing is buying highly economic gold in-the-ground for pennies on the dollar. Based on our research, the new secular bull market for precious metals is still in its infancy while the overall stock market is substantially overvalued and at risk of a major bear market.

Crescat Capital is a global macro asset management firm. Our mission is to grow and protect wealth over the long term. Our goal is industry leading absolute and risk-adjusted returns over complete business cycles with low correlation to common benchmarks. We encourage you to reach out to a Crescat representative to learn more about any of our five strategies. You can find both Marek Iwahashi and Cassie Fischer’s contact information below.


Kevin C. Smith, CFA

Member & Chief Investment Officer

Tavi Costa

Member & Portfolio Manager

For more information including how to invest, please contact:

Marek Iwahashi

Client Service Associate

[email protected]


Cassie Fischer

Client Service Associate

[email protected]

(303) 350-4000

Linda Carleu Smith, CPA

Member & COO

[email protected]

(303) 228-7371

© 2021 Crescat Capital LLC