Inflation Acceleration in 20016 Continues in 2017

1. Inflation Acceleration in 2016 Continues in 2017
Inflation has moved up in 2016, with most measures above 2%, the Federal Reserve
target. Given that the Housing Market Index (HMI) and other leading indicators to the
economy remain positive, inflation is expected to continue to accelerate in 2017.
Chart I

2. The chart above illustrates the year-over-year change for these four key measures of
inflation. On a year-over-year basis, the median CPI rose 2.6% and the trimmed mean
CPI rose 2.2% (both calculated by the Cleveland Fed based on data released in the
Bureau of Labor Statistics (BLS) monthly report for December 2016). The BLS also
reported for December 2016 that the CPI less food and energy rose 2.2%. Core PCE
(December) increased 1.7% year-over-year.
Given recent trends in inflation, a 2.5% or above forecast for core CPI inflation in 2017
seems reasonable (see Chart II). Inflationary expectations for the 30-year T-Bond yield
(yield on 30-year T-Bond less yield on 30-Year Tips) of 2.07% could well increase to 2.5%
or 3.0%, which lifts 30-year T-Bond yields from 3.1% to 3.5%, or even 4.0%, in 2017.
Bond prices would then decline significantly on 30-year T-Bonds. Inflation-indexed 5, 10
and 30 year T-Bonds would appreciate due to a positive inflation adjustment.
Chart II

3. How Does Higher Inflation Impact the S&P 500?
The Major Bull Markets in S&P 500 Driven by a Positive Differential
Between ROE less COE
Analyzing the S&P 500 from 1990 to present (see Chart III), the ROE for the S&P 500
rose above its Cost of Equity (COE as calculated by IDCFP)* in June, 1993 and rose to a
peak spread in March 2000. The S&P 500 rose from 452 to 1499, a 232% increase. The
Housing Market Index (HMI) predicted the peak in ROE in 2000 and the decline in ROE
below COE in 2001 and 2002 (see Chart IV).
The next bull market in the S&P 500 began in September 2002, as the ROE again rose
above COE. The S&P 500 increased from 815 in September 2002 to 1421 in March
2007, the quarter the ROE less COE spread peaked at 9.32% (see Chart III). Stocks
rose 74% in this bull market. The decline in ROE from 17.3% in 2007 to a low of 1.4% in
2009 was again predicted by the HMI (see Chart IV).
The current bull market was forecast by a positive ROE less COE spread in December
2009. ROE less COE spread rose from 2.73% on 12/31/09 to 9.78% on 12/31/2014.
COE, meanwhile, declined from 8.07% on 12/31/09 to 4.31% on 12/31/2014. The S&P
500 rose from 1115 in December 2009 to 2059 in December 2014, an 85% bull market
increase (see Chart III). However, the HMI continues to climb to new highs, indicating
further economic gains and a recovery in ROE in 2017 (see Chart IV). ROE peaked at
14.8% in 2014 and receded to 13.1% estimated for the year ending December 2016.
Since 2014, COE fell (due to lower interest rates) to 4.08% as of December 2016, from
4.31% in December 2014. The lower interest rates and COE allowed the S&P 500 to
reach marginal new highs in 2016.

4. Higher inflation in 2017 and 2018 forecasts a 3.5% to 4.0% yield in 30-year T-Bonds,
which, in turn, raises the COE to 5.5% to 6.0%. For the S&P 500 to maintain its
current price to book value of 2.9 times, ROE must increase as fast as COE to 13.0%
to 13.5%. The January 25, 2017 price for the S&P 500 of 2297 divided by the
December 31, 2016 book value of 796 provides a price to book value of 2.88 times.
Historic peaks in book value were normally 3 times book for the S&P 500 (see Chart
V). Book value for the S&P 500 could rise to 870 in 2017 for a valuation of 2610 and,
even, 1000 in 2018 for a valuation of 3000.
A bear market forecast for the S&P 500 would require a peak and decline of 10
points in the price to Housing Market Index (see Chart IV).
Chart III

5. Chart IV
* COE as calculated by IDC uses general risk as demonstrated by the 30-
Year T-Bond yield. A risk premium adjusts for another 50% of the 30-
year T-bond and 20% of the 5-year standard deviation of the ROE to
cover specific risk.

6. Chart V
IDC Financial Publishing, Inc. normally only focuses on bank stock
valuations, ROE, COE and price to book value. Given our unique “Cost of
Equity” (COE), IDCFP tested the concept against the S&P 500.

7. John E Rickmeier, CFA
President
IDC Financial Publishing, Inc.
700 Walnut Ridge Drive, Suite 201
PO Box 140
Hartland WI 53029
800-525-5457
262-367-7231
262-367-6497 Fax
jer@idcfp.com
www.idcfp.com