Professor of finance and valuation guru Aswath Damodaran believes that if investors underestimate expected inflation in the long term, as they did in the 1970s, the markets could see a prolonged period of weakness.
Given the market pricing today, and expected earnings and cash flows, stocks are very mildly overvalued, he said.
“I trust my judgments enough that I will leave my existing equity holdings intact, but I am not quite ready to jump in and make bets on market direction now,” Damodaran, professor of finance at the Stern School of Business, New York University, wrote on his blog.
Investors, he said, are expecting inflation to peak over the next year and subside in the long term, close to the levels seen in the last decade. “That may be hopeful thinking, and the returns on stocks and bonds over the rest of the decade will be determined by the correctness of this assessment; if investors are underestimating expected inflation in the long term, as they did in the 1970s, we are in for an extended period of malaise in markets,” he said.
“Given a choice between allowing inflation to play itself out and initiating polices that trigger a recession, there are some who are pushing for the former, arguing that trading off the certain pain that comes with a recession for the uncertain benefits of lower inflation is not good policy. High and volatile inflation corrodes economies and markets from the inside out, destroying faith in currencies and making investors and businesses behave in dysfunctional ways,” he added.
Damodaran also observed that the last decade has seen an explosion of risk capital, aided and abetted by central banks and policymakers.
“Inflation’s return to the center stage has, at least for the moment, broken the spell, and risk capital has withdrawn significantly from markets,” he observed.