Content provided by Sierra Morris, CLS Investment Analyst
Recently, I read a report from Crestmont Research that looked into the effects of inflation on the stock market. It stated that, contrary to popular belief, it is inflation, not interest rates, that tend to drive P/E ratios. Crestmont reported that both rising inflation and deflationary environments tend to decrease P/E ratios, while the valuation metric will rise in times of price stability. To illustrate this point, I have recreated their chart below. Take a look at the relationship between the two lines and how the P/E ratio moves in relation to the 12-month change in inflation over time. P/E ratios are a very important aspect and predictor of future returns within the equity market.
Because of the strong inflation and stock valuations trends, curiosity took me a step further to see just what these different inflationary environments would mean for stock returns. Using Robert Shiller’s database (recipient of the 2013 Nobel Prize in Economics), I broke 12-month periods of changes in inflation into nine separate buckets. From there, I went back to 1871 to measure what the markets historically returned during these inflation changes, as well as what the market returned one year out. So far, 2014 changes in inflation have been very moderate, placing us in “Bucket 7” shown below and bolded. I color-coded the returns, so the best returns of each category are shown in green, and the worst are in red. From this, we can see that generally the best place to be on this table is the buckets with moderate inflation or deflation – which is right where our current bucket 7 is!
In other words, historically when there has been an inflationary environment, such as the one we are in right now, the median return was 15% and the return that came one year later was 11.6%. Now if inflation ticks up a bit and places us into an environment like Bucket 6, historical median returns have been around 15.4% during that period and 15.4% one year later. While still a far cry from 2013’s blowout year, these are still great returns! Bottom line, while we are bombarded with information and noise claiming that the market is due for a correction, it is a good idea to go back and look at how things have performed in the past, rather than just reading headlines.
The price-to-earnings ratio is a valuation method obtained by dividing the market value per share by the earnings per share.