Stocks Shouldn’t Be This Pricey In An Environment This Inflationary

Stocks Shouldn’t Be This Pricey In An Environment This Inflationary
Stéphane Renevier, CFA

over 1 year ago2 mins

This chart shows the relationship between inflation and stock valuations. The vertical axis represents the Fed’s preferred inflation measure: the core personal consumption expenditure index (PCE), which tracks the price of goods, excluding volatile items like food and energy. The horizontal axis shows Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), which divides a company’s stock price by its average earnings over the past 10 years, adjusted for inflation.

The relationship is interesting: when inflation is low (say, below 2.5%), stock valuations can vary wildly (between 12x and 45x their adjusted earnings). But when inflation is high, as it is now, the amount that investors are willing to pay for the same amount of earnings shrinks. This makes sense: with inflation reducing the purchasing power of earnings and dividends, investors tend not to want to pony up as much for them.

Right now, however, stock valuations have disconnected from their historical relationship to inflation – and you can see that in the chart. The red dots represent valuations over the most recent months, from the furthest-right dot (December, 2021) to the furthest-left (May, 2022). With core PCE inflation currently close to 5%, you’d expect the CAPE to be between 9x and 22x. But it’s actually above 30x – and that suggests stock prices could fall – by anywhere from 27% to 70% to match their historical relationship.

Now of course, there may be other factors at play that could justify higher-than-usual stock valuations – consumers and companies are in much better financial shape for example. But when historical deviations are significant, you should always pay attention. And, as you can see as those dots trend further and further to the left, valuations appear to already be shifting toward their historical norms. To protect your portfolio against high inflation, you may want to rotate your stocks into real assets, like commodities, natural resources, real estate, or infrastructure, as we explained here.



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