Inflation troughs and PE peaks:
I've been looking at a graph of inflation for the last 40
years, and comparing it with a graph of the market PE (S&P
500, trailing). In that time, there were 6 inflation
troughs (including the latest, last year), and 5
corresponding peaks in the market PE. The latest PE peak,
the one corresponding to the inflation trough of first
quarter 1998, is not certain:
inflation trough, PE peak:
1961, 1961
1972, 1971
1976, 1975-76
1983, 1983
1987, 1987
1998, ????
As you can see, there is a perfect correlation. Every inflation trough has a closely associated peak in the market PE. Looking at the graph, it is not subtle at all. The subsequent declines in market PE are proportionate to the rise in inflation after the trough.
Several observations:
1. The CPI bottomed in 1Q1998 at 1.5%, and has since
increased to 2.1% If this was a true trough (and not just
a random movement within a continuing downward trend), then
we should have already seen the PE peak. In
all of the other 5 inflation troughs, the PE peaked
within a year, at the very latest. Last month (I think;
please correct me if I have this wrong), we just set a new
high on the PE, at 31. So, either inflation did not trough
last year, or the market is breaking a pattern that has
held for 40 years.
2. The PE contraction is proportional to the inflation
increase. Again, this is not subtle. It looks like a close
and robust pattern. As inflation soared from 5 to 15% in
1996 to 1981, the PE got chopped in half, from 12 to 6.
Ouch. The gentler 2% to 5% inflation upsurge in 1983-84
only caused a PE contraction of 13 to 10. A much littler
ouch.
3. If inflation increases in 2000, it probably is going to be a mild increase, maybe from 1.5% to 3.5% I think the odds of a massive inflation surge, like we saw in the 1970s and early 1980s, is small. That would indicate that the expected drop in market PE in 2000 will be fairly small, in the 20% area. If you pick the right stocks (not inflation-sensitive, and with reliable and growing earnings), you could even make money while the overall market PE contracts by 20%, from 30 to 24. But it would be tough.
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