By Jacob Sonenshine
Inflation is looking sticky, with the latest inflation reports signaling the Federal Reserve has more work ahead to reach its 2% annual target. Investors should scour for stocks that protect them.
The Consumer Price Index rose 2.7% year over year in November, in line with economists' forecasts and above October's 2.6%. The Producer Price Index for November rose at a 3% annual rate, beating estimates for 2.6%.
Stubborn inflation means the central bank may not be able to cut rates as many times as the market expected. While a cut is likely this month, the question is whether the Fed will keep cutting -- or even hike -- thereafter. Job growth has continued, consumer demand remains strong, and Trump's impending policies could keep inflation above 2%.
If the Fed keeps rates higher, that could easily dent the broader stock market. The S&P 500 is up 28% this year, partly reflecting expectations the central bank will keep lowering rates and the economy won't experience much interruption to its expansion.
"Uncertain inflation, rates, economy = volatility stays elevated," writes Cliff Corso, president and chief investment officer of Advisors Asset Management.
Barron's identified stocks that can insulate investors from volatility. We looked at the correlation between the monthly percentage movement in each S&P 500 stock versus the change in the CPI's growth rate each month to see which stocks perform best when the rate of inflation rises.
Well-known names in the top quintile include: Coca-Cola, Lowe's, Exxon Mobil, Steel Dynamics, Chubb , MetLife, Berkshire Hathaway, JPMorgan, Wells Fargo, Invesco, United Parcel Service, FedEx, Eli Lilly, and Merck.
Another is Caterpillar. Its stock rose 16% in 2022, while the S&P 500 dropped 19%, as the market anticipated the Fed would hike rates many times in response to rising inflation.
Caterpillar, the global leader in selling equipment, has demonstrated the ability to lift prices without denting demand too much, thereby keeping earnings growing. Sales grew 16% to $59.4 billion in 2022.
That is why its operating profit margin increased that year, sending earnings up aggressively. This gave analysts confidence to boost their earnings estimates for the following year, 2023, as Caterpillar's stronghold within its business and pricing power helped it stand out.
Meanwhile, aggregate earnings estimates for S&P 500 companies dropped. Analysts could see demand for most products and services would suffer from inflation and higher rates.
Today, Caterpillar can pull off a repeat of the past. Sales dipped by $2 billion this year to what analysts expect to come out to $65.3 billion, according to FactSet. But analysts expect sales to rise almost 3% annually over the next two years to just over $69 billion in 2026.
The reality is that the economy is still growing and Caterpillar said on its third-quarter earnings call it is positive about the long-term growth of its segments. Chief Financial Officer Andrew Bonfield even mentioned that, "since early 2022, price realization has been strong and has often exceeded our expectations."
Any resulting earnings growth could easily spark outperformance versus the broader market. Shares trade at about 17 times expected earnings for the coming year, below the S&P 500's 22 times, though Caterpillar often trades closer to the index when it is firing on all cylinders.
Elsewhere, Trivariate Research also screened for stocks with high correlations to the CPI. The strategists adjusted for the stocks' betas, which measures whether a stock is more or less volatile than an index it is listed on. Without doing so, one would find some stocks that outperform the S&P 500 when inflation rises but still see an outright decline in price. By adjusting for betas, Trivariate identified more names that see outright gains when inflation is higher.
Examples include McKesson, H&R Block, and Corteva.
Another is E.l.f. Beauty, which had a 70% stock increase in 2022. The maker of lower-priced makeup saw sales more than double from 2021 to $912 million in 2023 as people ventured outside their homes again. E.l.f. also took market share from competitors by marketing on TikTok and winning more shelf space at mass retailers. While it sold more products, it also raised prices over those two years, lifting earnings up more than twofold.
For the next two years, analysts expect 17% annual sales growth to $1.7 billion in 2026. E.l.f. can continue to take share, especially because it is still a small player in a large category. Beauty demand also tends to remain fairly sturdy, even when consumers broadly pull back on spending.
Earnings growth would move the stock higher. It trades at 32 times earnings, below its peak this year of 62 times.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
December 15, 2024 18:50 ET (23:50 GMT)
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