Valuation Conundrum

US equity market valuation is puzzling. With the S&P 500 priced at 24x trailing earnings, stocks look expensive and long in the tooth — the market has persistently traded above average valuation levels since 2013.  Meanwhile, economic conditions have been, at best, lackluster over the same period.  As earnings and the business cycle inch towards contraction, investors must question when market valuations will tighten.

But bull markets don’t die of age and 24x certainly isn’t the highest P/E we’ve seen.  Besides, there’s more to the story than duration and multiples.  There’s the invisible but ubiquitous phenomenon we call inflation.   Historically periods of low inflation have coincided with high market valuation levels. Likewise, periods of high inflation have seen low valuations levels.

The two variables don’t move in lockstep, but with a negative correlation of -0.27 the relationship doesn’t seem totally spurious either.  And logically, it makes sense.  When inflation is high, future earnings (the denominator in the P/E) are worth less and should be valued at a higher discount rate. That results in a lower current price and a lower earnings multiple. And yes, this actually happens in reality. Just consider how higher inflation leads to higher interest rates.

The reverse is true in the US where inflation and interest rates have been low. The point is, though a 24x P/E looks high relative to the long-term average of 16x, it seems less so considering inflation.  In fact, the current P/E is near the average among historical values during low inflationary periods.  The graph below shows this by plotting annual current P/E over annual CPI from January 1930 to April 2016.  The red circle shows where we are now, and the regression line highlights the negative, albeit slightly so, slope

Data from US Bureau of Labor Statistics and Online Data Robert Shiller

Based on this data it looks like P/Es have commonly been above 20x until inflation gets to about 4%. Above 5%, P/Es have rarely been able to stay above 20x.  With headline CPI currently around 1% (and the core figure just above 2%), valuations could stay higher for longer.  Does that mean US stocks are a bargain?  No, of course not.  Even adjusted for inflation they’re not cheap.  They’re simply not as expensive as a cursory comparison to historical multiples might imply.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss.

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