DEEP DIVE: The Valuation Question

The air continued to come out of valuation multiples last week, as inflation remains persistent and interest rates remain elevated.

There’s an inverse correlation between the S&P 500’s P/E and the CPI inflation rate on a y/y basis (Fig. 1). We have quarterly data starting in 1936 for the P/E based on four-quarter trailing earnings and based on monthly forward earnings since January 1979. The CPI inflation rate is available monthly over this period. During periods of falling and low inflation, our composite P/E tends to rise and exceed its historical average of 15.0 (Fig. 2). During periods of rising and high inflation, the P/E tends to fall below its historical average.

On Friday, the forward P/E was 15.1, the lowest since April 1, 2020 but about at its historical average (Fig. 3).

The composite P/E is also inversely correlated with the 10-year bond yield based on data available since 1953 (Fig. 4). The correlation isn’t as tight as with the inflation rate. The S&P 500 forward P/E peaked last year at 22.7 on January 8. So its drop since then to 15.1 certainly can be explained by the jump in both inflation and interest rates since then.

The question is whether the P/E will hold at its historical average or fall below it. The answer depends on whether the US economy is heading into a hard-landing recession. If it is, then the forward earnings of the S&P 500 will fall along with both forward revenues and the profit margin. In this scenario, the forward P/E would likely fall below 15.0 on its way to the high single digits, as happened during previous recessions.