The Effect Of Inflation On P/E Ratios

The current accommodative stance by the Federal Reserve can’t last forever. Everyone is nervously casting about in search of inflation these days. Bond yields (30 year Treasuries) have crept up to almost reach their 52 week highs. Obviously we are seeing inflation in the commodities markets but that has yet to be officially translated in the consumer inflation numbers. By the way, the CPI numbers will be released next week (February 17th) and we’ll see where we stand then.

In the meantime, the important question is what effect will inflation have on P/E ratios if and when it does arrive? Last week, with the help of informative charts and research from Crestmont, I suggested that P/E ratios, not earnings were the definitive variable to watch.

Today I wanted to share with you another piece of research from Crestmont which shows the relationship between P/E ratios and inflation. The relationship seems rather strange at first but more or less it can be approximated by a sideways “Y” shape, hence the usual name for it: the “Y-Curve”.

Source: Crestmont Research

The best conditions for “animal spirits” or normal to high price earnings ratios are for a manageable amount of inflation. We run into major problems when we have high inflation or deflation.

Source: Crestmont Research

What I’d really like to see is a chart showing CPI for a year and then the 10 year CAPE going forward from that year. I’m going to go and play with some data to see if it presents us with anything of further interest.

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4 Responses to The Effect Of Inflation On P/E Ratios

  1. PEJ says:

    The main issue that I see is that CPI is a very poor indicator of inflation. It would probably be a lot more meaningful to perform something similar but using a real measure of inflation: TMS or maybe the total of change in currency and aggregate credit growth or something similar (you get the picture)

  2. Babak says:

    Pej, I agree that CPI is an imperfect measure but each one has a weakness. Also, each measure comes with its own bias. For example, TMS was birthed from an Austrian perspective and it is incredibly volatile. The year over year % change hit +500% in 2009!

  3. Pingback: Inflation & P/E Multiple Contraction/Expansion | tradersnarrative

  4. PEJ says:

    Good point Babak. Yet, who can believe that real “price inflation” was two percent annualized when house prices were doubling every 18 months and gasoline was moving from $2 to $4 a galon?

    CPI is such a biased measure of “price inflation” (not really “monetary inflation”) that, it is almost useless to everyone but monetary authorities who want to look for a good reason to always inflate more.

    Consequently, and with all due respect, the foundations of this analysis are rotten.

    PS: I don’t like this “subscription mechanism” that WordPress if forcing on us (with the confirmation email)

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