Home / Markets / Stock Markets /  Ashwath Damodaran's warning to stock market investors

Finance professor and valuation guru Ashwath Damodaran believes that if investors are under estimating expected inflation in the long term, as they did in the 1970s, we are in for an extended period of malaise in markets.

Investors are expecting inflation to peak over the next year and subside in the long term, close to the levels that we saw 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 under estimating 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 in his blog on Monday.

While Damodaran said he remains a skeptic on inverted yield curves as cannot-fail predictors of recessions, the message in the distortions in the yield curve on September 23, 2022, is not a positive one about the future of the economy.

The first and second order effects of inflation have been significant and damaging, but the question that remains unanswered is about the long term effects on the economy, and more importantly, on investor and consumer psyches.

“Having spent all of 2022 trying to hit a moving target on expected inflation, and the resulting interest rate, the one guarantee for the future is that there is more change coming. To make a judgment of direction, we have no choice but to take a stand on where inflation will settle in after supply chains are fixed, COVID is in the past and perhaps after the economy has cooled down. If we will revert back to inflation of 1-2%, as the market seems to believe we will, we will face a very different end game than if we revert back to 1980s levels of 3-4%," he added.

If one is bullish, the assumption that makes the biggest difference is where you see equity risk premiums converging, with premiums closer to 4% yielding undervaluation on the index, even with significant earnings shocks built in, as per Damodaran. 

At the other end of the spectrum, if the equity risk premium stays at 6% or higher, the only scenario where one arrives at a value close to the index is if the 10-year T.Bond rate drops to 2% and earnings estimates come in as expected, with significant corrections to come, he explained.

“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.

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