Equities continue to grind out new record highs, leaving U.S. stocks expensive relative to both history and other countries. Many investors believe the high valuations are justified given still historically low interest rates and inflation. Unfortunately, the regime may be changing in a way that would be less friendly to elevated equity multiples. One dimension of that change is inflation.
Headline inflation has been rising as oil prices have rebounded. The consumer price index (CPI) is now running at 1.60% year-over-year, double the level in July. This is important for market multiples, which historically have been higher when inflation is lower.
Going back to 1954, the level of the CPI has explained approximately 35% of the variation in the S&P 500’s trailing price-to-earnings ratio (P/E). While the relationship has tended to be less linear with inflation at very low levels, as is the case today, there is another dimension of this relationship that is worth watching: the volatility of inflation.
The relationship between equity multiples and inflation
In the past, equity multiples have been highest when inflation is not only low but stable. Historically, the five-year trailing standard deviation—a measure of volatility—of CPI has explained roughly 30% of the variation in market multiples. The relationship between inflation volatility and multiples holds up even after accounting for the level of inflation. In fact, a model that accounts for both the level and volatility of inflation has explained roughly 60% of the variation in market multiples.
These relationships are important because today inflation is rising and becoming less stable at a time when stocks are particularly expensive. The S&P 500 trades at approximately 20.5x trailing earnings, putting multiples in the top quintile (20%) of all observations going back to the 1950s. Put differently, over the past 62 years the market has only been more expensive roughly 16% of the time. Looking at a longer-term metric, the cyclically adjusted P/E ratio, markets are even more expensive. Based on this metric, which uses longer-term earnings, the market has only been this expensive during the tech bubble or right before the 2008 crash.
In short, today’s valuations are still supported by low inflation and relatively low rates, but that regime may be shifting. Even if inflation remains low by historical standards, should it start to become unmoored, that would remove another prop supporting equity market valuations. For investors, this suggests two strategies.
First, don’t abandon international diversification. Markets are cheaper outside of the U.S. Second, emphasize more of a bottom-up approach, emphasizing those parts of the U.S. market, notably cyclical companies and health care, where multiples are less stretched.
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