The stock market is worth the level of the major indices. It’s not overvalued and it’s not undervalued either. It’s just about right as far as I’m concerned. The economic data are supportive and so are corporate earnings. What’s impressive is the breadth of the recovery. Manufacturing is improving and so is retail. Technology is showing major sales growth and industrial companies are ramping up on earnings. While I’m wary about the right shoulder formation of the S&P 500 Index, on balance, I feel pretty good about the current equity environment.
Last year, one of the most important trends that developed in big corporations was their ability to increase their selling prices without materially affecting demand. They told us so, right in their earnings reports. The increase in prices was only modest, but this trend is still occurring, and it’s a great sign that the economy is getting stronger.
Take, for example, The Dow Chemical Company (NYSE/DOW), which is a great benchmark company for the industrial sector. In its latest quarter, the company reported a 10% increase in sales to $13.8 billion, but earnings increased tremendously to 426 million dollars from 87.0 million dollars. Total sales volume grew 12% during the fourth quarter and prices grew 10%. The company’s North American operations led the way with a 25% improvement in sales and operating margins improved for the seventh consecutive quarter.
Most large, international companies have been reporting great numbers because of the growth they’ve experienced in emerging markets like India, Russia, China and Brazil. It’s really helpful then to see a big industrial company like Dow Chemical say that its domestic business is really improving.
The big question for the economy and the stock market is obvious: can the momentum continue? From my perspective, the answer is, yes, but subject to the ferocity of inflation.
Some price inflation is helpful. Companies have been able to raise their prices without hurting demand, and that’s good. There is a supply chain out there and it does take time for prices to trickle down; but, as we all know, commodity prices are very strong and that’s been across the board. Raw materials for virtually all businesses are about to get a lot more expensive and this pressure will eventually work against demand while at the same time weighing on interest rates.
The momentum can continue, but only if inflation is kept under control. Not too hot and not too cold. That’s what we need. I expect the Federal Reserve to make a major policy change this year, and it will be to try to control inflation, which we know is now creeping into the system. This could be the catalyst for a major correction in equity prices. Without this change in policy, however, we risk runaway inflation around the globe and that would not be a good development for equity investors.