A common theme of this blog has been that valuation data, in order to be useful, should not be looked at in isolation, but rather should be viewed in the context of inflation. That inflation does matter to equity valuations and bond yields can easily be seen in the chart below, which shows the S&P 500’s earnings yield (the inverse of the P/E ratio), the S&P 500’s CAPE yield (the inverse of the CAPE ratio), and the 10-year Treasury bond yield versus the rate of inflation. In the postwar period, particularly since 1960, all four have tracked one another very closely:
Given all the angst over current U.S. equity valuations, I wanted to revisit a post I wrote a while back in the midst of a market selloff. The idea was to frame prevailing valuations in the context of historical averages relative to inflation, specifically in inflation regimes with either greater or less than 3%. Then, in January of 2016, when the market was selling off, the S&P 500’s price-to-earnings ratio based on the last twelve months’ earnings was about 20, the S&P 500’s CAPE or “Shiller P/E” was about 24, and the ten year Treasury bond was yielding 2.09%.
Given that the market has risen more than 36% since that earlier article’s publication, I thought it would be helpful to revisit those data points to see where things stood currently. Here are the results:
In contrast to January of 2016 when the S&P 500 was more or less in-line with historical averages for periods of less than 3% inflation, current valuations are considerably higher than average. It should be stated, of course, that valuation-based market timing is a foolish endeavor, but it seems clear that at least based on postwar averages, both stock and bond valuations are currently pretty rich, despite benign inflation. Prudent investors, I believe, should prepare for a period of low returns, diversify accordingly, and attempt to offset probable lower future returns by saving more.
