Investors are in a 'Barbie'-style fantasy as they brush off market risks, Smead Capital Management CEO warns

• Investors are living in a "Barbie"-style fantasy world where everything's great, Cole Smead says.
• They're ignoring the risks of inflation, more interest-rate hikes, and larger bond yields, he says.
• Those threats are likely to flatten stock-market returns in the years ahead, the fund manager says.

Stockholders are living in a "Barbie"-style dreamworld if they think stubborn inflation and high interest rates won't crush their future returns, Cole Smead says.

Investors can earn a risk-free 5.5% return from 3-month Treasury bills today, Smead Capital Management's CEO and portfolio manager noted in a memo titled "Stock Investors in Barbieland" on Tuesday. Stocks should have declined to reflect their relatively less attractive returns versus bonds, and the greater risks they pose to investors, he said.

"When you see short-term rates move over 500 bps, something should markedly change in how investors value assets," he said. Despite the "tectonic rise" in yields, the S&P 500 remains highly valued on both a price-to-earnings and price-to-book basis, he continued.

Indeed, the S&P 500 has jumped 16% and the Nasdaq Composite has surged 32% this year. Many investors have piled in because they're excited about artificial intelligence, and hopeful the Federal Reserve can crush inflation without raising interest rates too high and causing a recession.

Inflation spiked as high as 9.1% last summer, spurring the Fed to hike interest rates from nearly zero to north of 5%. The central bank's efforts have helped to slow the pace of price growth hto about 3% in recent months, not far off its 2% target.

However, inflation acts like "gravity" on stocks, and if it accelerates to 4% or 5%, the Fed could hike rates more than expected, Cole said.

The market's disregard for those risks indicates that "stock investors are just another Ken in Barbieland," Smead said. "After all it's a fantasy land."

"The higher nominal rates that inflation may cause are not being considered by stock investors in valuing individual businesses or the stock market at large," he added.

The upshot is the fund manager expects the twin pressures of lingering inflation and larger risk-free returns to weigh on stocks.

"These valuations won't go up like a six-inch heel," he said. "Flats may be more fitting for thinking about stock returns going forward."

Smead's father and the fund's chief investor, Bill Smead, issued an even more pessimistic outlook in August. He warned the AI frenzy had surpassed the internet hype of the late 1990s and early 2000s, and declared it was bound to end badly.

"This financial euphoria episode has gone to a sustained high that makes the dot-com bubble look like small change," he wrote. "Manias die in vicious ways."