While the stock market experienced an unusually strong first half of the year, market participants are grappling with a number of issues. Inflation, future Fed rate hikes, and stock valuations have some people concerned. The push and pull between these factors has made for a choppy market over the past few months. We do not think these issues should distract investors. We have consistently written about the positive fundamental backdrop, outstanding corporate earnings, and underlying health of the market. While we know any of the risk factors above could trigger a market decline, investors should focus on the positive drivers as they should ultimately power the market higher through the end of the year.
We wrote a commentary specifically about inflation in May, which we encourage you review. In short, we do not expect inflation to be a particularly big problem going forward. Many of the factors driving higher inflation today are pandemic-related; we expect these pressures to abate in 2022. Longer-term forces such as the increased adaptation of technology and aging demographics should serve to keep inflation in check in the coming years. It is also worth noting that historically modest inflation correlates with strong stock markets, as they include periods of strong economic growth. We think this is likely to happen in the next few years. Furthermore, we have purchased stocks that benefit from higher inflation in client accounts.
Recently, some investors have become concerned that the Fed may raise rates sooner than originally anticipated, which could be a headwind for stocks. We do try to predict Fed activity. We point out that market returns are typically strong in the 12 months prior to the first Fed rate hike, and continue to be strong 36 months after according to data from Credit Suisse. Returns typically weaken towards the end of a rate hike cycle, not the beginning.
Stock valuations are not cheap. However, we think that valuations are likely overstated. We have written about how companies have consistently exceeded analyst expectations with both stronger-than-expected revenue and cost-cutting. Eventually this will normalize, but we see the potential for very large earnings beats to continue for a few more quarters. Factoring that in, actual valuations are lower than they appear.
We know that a market pullback is likely at some point, perhaps even in the next quarter. But we reiterate that the positive drivers in the market should win out in the long run. We will continue to stay true to our process to keep you invested appropriately.
