If Inflation Stays This High, Stocks May Have A Long Way To Fall: 1982-Level Inflation Could Mean 1982-Level Stock Valuations.

The other kind of inflation (Svets Anna/Pexels). 

Inflation Hits The Highest Level Since 1982

The big economic headline last week was CPI data showing inflation rising 7% year-over-year in December, the highest rate since 1982. Economist Eric Falkenstein suggested on Twitter that it may be even higher, judging by real estate data. 

Let's suppose that the CPI reading is accurate though, and inflation is "only" running at 7% now. What might that mean for stocks? That depends on whether the inflation ends up being persistent. Portfolio Manager Meb Faber offered some words of caution in the event that it is. 

1982's Inflation, 1982's Stock Valuations

As Meb Faber pointed out, historically, inflation levels this high mean stock valuations that are much lower. 

When question about where he got those numbers, Faber pointed to Yale economist Robert Shiller's data. Faber mentioned ten-year average P/E valuations in his initial tweet, but Shiller also shows the one-year P/E multiple for stocks in 1982 the spreadsheet he links to on his site. It was about 7.6. The trailing one-year P/E ratio now is 24.2. 

Maybe the Fed tightening, plus the drying up of COVID relief dollars will bring inflation down in short order. In case it doesn't, here's a way you can hedge against the risk of stocks tanking over the next several months. 

Hedging Market Risk 

Here's a simple way of protecting a $500,000 stock portfolio against market risk using optimal, or least expensive, puts on the SPDR S&P 500 Trust ETF SPY. You can use this approach with a $50,000 portfolio or a $5,000,000 portfolio too: just adjust the dollar amount you use in Step 1. For the purposes of this example, we'll assume your portfolio is closely correlated with SPY, that you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 20% over the next few months (if you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold).

Step 1

Divide $500,000 by the current price of SPY, which was $464.58 as of Friday's close, to get 1,076 (rounded).

Step 2

Scan for the optimal, or least expensive, puts to protect against a >20% decline in 1,076 shares of SPY over your desired time frame. Here, I've used our default setting, which is to scan for optimal hedges expiring in approximately six months.

This and the subsequent image are screen captures from the Portfolio Armor iPhone app. 

Note the cost here: $9,650, or 1.93% of portfolio value, which was calculated conservatively, using the ask price of the puts (in practice, you can often buy options at some price between the bid and ask prices). That worked out to an annualized cost as a percentage of portfolio value of 4.63%.

Step 3

Round up the number of SPY shares to the nearest 100 and repeat step 2.

Note that, in this case, it was cheaper to hedge rounding up to the nearest round lot: The cost was $6,391, calculated conservatively again, at the ask. That's about 1.25% of a $500,000 portfolio, or 3% annualized. Might be worth it if you're worried about a return to 1982-style stock valuations. 

What About Your Bonds? 

You can use the same approach as above, substituting a bond proxy for SPY. So, for example, the iShares 20+ Year Treasury Bond ETF (TLT) for long-dated U.S. government bonds, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) for corporate bonds, etc.