- Leon Cooperman thinks inflation is a friend of common stocks, suggesting investors should embrace high prices.
- Despite inflation being the central driver of January's market sell-off, experts say rising rates can actually be welcome for investors.
- Sectors like energy, financials, basic-materials, and real estate have outperformed in inflationary times.
Inflation is a "friend of common stocks." While these words might run counter to the "inflation hurt stocks" narrative that dominated the market in January, billionaire Leon Cooperman believes that rising prices pressures and higher rates can actually work in the favor of equity investors.
Companies absorb the effect of rising costs by raising their selling prices and protect their profit margins, which lifts the nominal level of their revenue and earnings, the Omega Advisors chairman explained in a CNBC interview last year.
In essence, he meant companies have the ability to pass the burden of higher costs to consumers. They can then use this extra cash to take decisions that will please their shareholders, like raise dividends or announce share buybacks.
Cooperman's comment might seem unreasonable at this time, considering January's sell-off was dominated by the fear of interest rate hikes (to cool red-hot inflation) and reduction in the Federal Reserve's bloated balance sheet, which could force bond yields and borrowing costs even higher.
But he might have a point.
Investors have shifted their focus from last month's fixation on inflation to scouring corporate earnings and growth prospects. What's encouraging to them is that over 75% of S&P 500 companies have posted a positive revenue surprise for the last quarter of 2021, according to data from FactSet.
Could inflation be friendly to stocks?
Consumer price inflation hit 7% in December, as the cost of common goods and services shot up. That means US inflation is the highest in nearly four decades. It means every dollar buys less now than it did at this point last year.
"Inflation reduces your buying power, which means you lose value holding cash. It's also very detrimental to fixed-income securities," said Anthony Denier, CEO of trading platform Webull.
"But, historically, stocks have been considered a hedge against inflation. This is because even as companies experience rising costs in the materials or resources to make their products or services, they have the ability to raise their own prices."
He gave the example of small-cap stocks, oil stocks, and emerging market stocks as examples of outperformers in this kind of environment.
Small-caps, or companies with a market value below $2 billion, typically do well in inflationary times because they serve niche markets, giving them more power to raise prices, Denier said.
Sector winners and opportunities
Specific sectors like commodities, real estate, energy, and basic-material producers also benefit from price rises. One defensive strategy is to analyze hidden gems that have superior earnings growth prospects.
And 2021 was a perfect example of high inflation, in which the leading sectors in the stock market were energy, commodities, and real estate, according to Matthew Stratman, lead financial adviser at South Bay Planning Group.
Financials, industrials, and materials are other safe sectors in this period, according to Greg Bassuk, CEO of AXS Investments.
"These stocks have benefited historically in such environments from increases in the rate of rising costs of goods and services," he said.
Play it safe
While inflation can be good for stocks in certain sectors, it's still worth being skeptical of tech stocks, as much of their current valuation is based on an expectation of future profitability - something that rising inflation can undermine.
Tech stocks benefit from low borrowing costs, so these don't do well when interest rates are raised to fend off inflation, said David Morrison, senior market analyst at Trade Nation.
"They also tend to be overvalued relative to value stocks, so are the first to be sold when financial conditions tighten. So, it's the old-school companies that can best weather inflation," Morrison said.