The Week in Review: May 24, 2021
Inflation and Stock Market Performance
A Google search of the word “inflation” has more than doubled since the beginning of the year. It’s up more than threefold 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.
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 five 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.
If you have any questions or concerns, please don’t hesitate to let me know.
Two for the Road
On May 15, 1997, Amazon held its IPO at a price of $18 per share. Notably, $10,000 invested on that day would be worth more than $12 million today—a growth rate of roughly 120,000%. —Investopedia, May 15, 2021
It took Amazon 13 years to deliver a 10,000% return to investors. It took Dogecoin five months. —Yahoo! Finance, May 4, 2021
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1. The Dow Jones Industrials Average is an unmanaged index of 30 major companies which cannot be invested into directly. Past performance does not guarantee future results.
2. The NASDAQ Composite is an unmanaged index of companies which cannot be invested into directly. Past performance does not guarantee future results.
3. The S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly. Past performance does not guarantee future results.
4. The Global Dow is an unmanaged index composed of stocks of 150 top companies. It cannot be invested into directly. Past performance does not guarantee future results.
5. CME Group front-month contract; Prices can and do vary; past performance does not guarantee future results.
6. CME Group continuous contract; Prices can and do vary; past performance does not guarantee future results.