Has the Market Gotten Ahead of Itself?

On this episode of The Long View, Aswath Damodaran, author and professor of finance at the Stern School of Business at New York University, was interviewed at the Morningstar Investment Conference in April.

Here are a few excerpts from Damodaran’s conversation with Christine Benz and Jeff Ptak.

Rising Interest Rates and Inflation

Christine Benz: We wanted to switch over to talk about interest rates and inflation a little bit. You’ve talked about how it’s important to distinguish between expected and unexpected inflation as well as the level and stability of inflation and estimating inflation’s potential impact on the value of riskier assets. Can you explain that?

Aswath Damodaran: Let me give you two countries you can invest in, one has an inflation rate of 5%, the other has an inflation rate of 2%. But as to which country would you invest in? The answer that most people would give is the 2% inflation rate, right? But let me add criterion there. Let’s suppose the country with 5% inflation, the inflation is going to be 5% guaranteed every year forever. The country with the 2% inflation is going to have 0% some years, 4% other years. I would take the 5% guaranteed inflation every year because I can now build a business on the expectation that inflation is going to be 5% every year. It’s not inflation per se that troubles people. It’s the fact that high inflation usually comes with more uncertainty about inflation, and what throws people off is being able to plan for that.

What Distinctions Matter When It Comes to Inflation?

Jeff Ptak: You made some other distinctions, too, in recent interviews. I’ve heard you talk about the difference between small and large firms, durable and discretionary demand, subscription-based versus transactional models, unregulated and regulated businesses—distinctions that you’ve said can impact how a firm performs in an inflationary climate. Why do these distinctions matter, in your opinion?

Damodaran: Because it’s a question whether you can pass inflation through on short notice to your customers. If you’re a regulated company, you need to go in front of a regulatory authority. They might agree or disagree with you. So, if you’re a utility and inflation is 7%, you might not get the 7% increase right away because regulatory commissions take months to act. So, those are things that affect how quickly you can react to inflation, and the quicker you can react to inflation and the easier you can pass it through, the better equipped you are to deal with inflation. It’s one reason I think the FANGAM stocks [Facebook (now Meta META), Amazon.com, Netflix NFLX, Google (now Alphabet GOOGL), Apple AAPL, and Microsoft MSFT] are back in action this year—now they’re going up—is if you think about those stocks are the quintessential pricing power stocks. Apple has no trouble passing pricing through. There’s nothing stopping them, they’re unregulated, they have complete competitive advantages. The more pricing power you have, the better equipped you are as a company to deal with inflation and all of those things can affect your pricing power.

Are Large or Small Firms Firms Better Equipped to Deal With Inflation?

Ptak: The one that seems most counterintuitive to me, and you’ve explained it quite cogently, is large versus small. Maybe intuition would suggest that a larger, better-equipped player that perhaps has a dominant perch in its industry would possess pricing power. But I think that you’ve explained that a small firm for reasons of maneuverability might be able to withstand the climate a little bit better.

Damodaran: I was trying to explain the 1970s, the last high-inflation bout where small-cap stocks outdid large-cap stocks. And here’s the big test. I don’t know whether that’s still going to hold now because the small caps of today are not like the small caps in the 1970s. So, I’ll take whatever explanation you have for the 1970s small-cap phenomena with a grain of salt here, because we’re in a different environment. Small caps now might be the ones without the pricing power. It’s still an untested proposition. We’re watching an experiment in motion without knowing what the outcome is going to be, but that’s the way markets are. Markets don’t repeat themselves. There’s always a surprise.

Has the Market Gotten Ahead of Itself?

Benz: The S&P was recently at 4,133, which is just a touch lower than the level you’d estimated it would be at in a scenario where inflation subsided to prepandemic levels, and we avoided a recession. Does that seem like the most likely scenario to you at this point? Or has the market gotten ahead of itself?

Damodaran: In a sense, what you will see with that is swings in the market. Take just this month—in January, markets were benign. The scenario of inflation coming down and no recession seemed to be the accepted story. In February, they went complete opposite, 180 degrees. There were some malignant scenarios, inflation is back, the world is ending. The first half of March with the banks failing, we’re again back, and the second half of March, we’re back to being in a good mood again. April has been good so far. I would not be sure that this is the end game. I have a feeling that until inflation switches off or is at least lowered, the inflation heat is lowered, you’re going to see swings in this market, good months followed by bad months. If you think about 2020, it was a bad year, but in August of 2022, we were up 9%. There are good months embedded with bad months. We still have to wait and see how that plays out.