Inflation and Stock Market Performance - May 24, 2021

A Google search of the word “inflation” has more than doubled since the beginning of the year. It’s up more than three-fold since last summer, according to Google Trends, as of May 9. 

April’s big increase in the Consumer Price Index (CPI) encouraged a surge in online searches, but inquiries had already been in an uptrend.

Is an unwanted jump in inflation something investors should be concerned with? For those on a fixed income, inflation is an unsettling prospect simply because rising prices eat away at the purchasing power of a pension or fixed income stream.

But for those who are invested in a well-diversified portfolio of stocks, the answer is a bit more complicated but one that should be addressed.

This week’s Insights will briefly take us into the weeds, but please bear with me.

Let’s look at one metric that measures stock market valuations using what’s called the P/E ratio, or Price/Earnings ratio, and how it relates to various levels of inflation.

The P/E ratio is as intuitive as it sounds: it’s the stock price divided by earnings per share (EPS).

We can also measure the valuation of a broad-based stock market index such as the S&P 500 Index.

If we take the current level of the index, which hovers around 4,000, and divide it by the earnings per share of the S&P 500, we quickly determine what investors are paying for each dollar of earnings.

Using last Thursday’s S&P 500 close of 4,159.12 and dividing it by projected EPS of $190.50 over the next 12 months (Refinitiv) for the S&P 500 Index, we get a P/E ratio of 21.8.

Simply put, this means that investors are placing a value on the S&P 500 of 21.8 times projected EPS of $190.50. That’s all it means.

Yale economics Professor Robert Shiller said he doesn’t know of any valuation indicator, with a record extending as far back as the 1950s, whose predictive power is significantly better than zero (WSJ). Data compiled by Seeking Alpha suggests little predictive ability out 5 years.

In other words, stocks may remain above or below the long-term average P/E ratio for years.

But what if we throw inflation into the mix? Higher inflation has historically reduced valuations. With an annual inflation rate of 0-2%, the average P/E ratio using projected earnings over the next 12 months is 17.8. It falls to 8 when inflation has averaged above 12%.

Why might valuations contract when inflation is higher?

High inflation can lead to sharply higher interest rates, which can reduce the attractiveness of stocks. High inflation also dilutes real earnings. For example, if earnings rise by 10% and inflation is 2%, real earnings growth = 8%. But if inflation rises to 9%, real earnings = 1%.

This exercise is simply conducted for educational purposes. In no way does it suggest inflation will move permanently higher over a longer period, as we saw in the 1970s.

Additionally, today’s P/E ratio would suggest stocks are overvalued based on current inflation. However, interest rates are very low, which provides greater support for a higher P/E ratio.

Much goes into the valuation equation. There are no simple tools to time the stock market. We know that over long periods, stocks have had an upward bias. We also know that stocks are not immune to pullbacks. Yet, well-diversified investment portfolios help capture some of the upward bias while helping to manage risk.