Stocks Are Cheaper, Sure, But They’re Not Cheap Enough

Stocks Are Cheaper, Sure, But They’re Not Cheap Enough
Theodora Lee Joseph, CFA

over 1 year ago2 mins

Mentioned in story

“Is it time to buy the dip yet?” is a fair question to ask, with stocks down by over 20% this year. But with inflation as hot as it is, you might not like the answer. Over the past 60 years, stock valuations have been lower when inflation’s been higher.

It's not difficult to understand why: high inflation is bad for consumer spending as it decreases “real wages” and forces people to buy fewer things, negatively impacting a company’s growth and profit margins. And it necessitates a central bank response – higher interest rates to tame spiraling prices. Interest rates are a core component in calculating a company’s cost of capital, which is the minimum rate of return or profit a company must earn before generating value. As interest rates increase, the cost of capital increases, lowering the present day value (and valuation) investors are willing to pay for a company’s future growth.

The chart above shows where the S&P 500’s trailing price-to-earnings (P/E) ratio has historically been, based on various yearly levels of core inflation, as measured by the Personal Consumption Expenditure (PCE). It shows that with core PCE most recently at 4.9%, the P/E would typically be around 15.2x – at least 16% below the current P/E of 18.1x.

There are two important takeaways: firstly, stocks aren’t cheap enough yet, at least based on this metric, and can dip further if high inflation lingers. Secondly,we're likely looking at a "new normal" of lower stock valuations, especially if you expect a higher long-term rate of inflation above the traditional 2% target. Yes, stocks may look cheaper relative to where they’ve fallen, but don’t anchor how cheap they are based on how they previously traded. Higher long-term inflation and higher interest rates mean that normalized stock valuations will be lower than where they once were. So the “dip” you’re looking for might not be the dip you were expecting.



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