{"id":145669,"date":"2022-06-28T15:00:57","date_gmt":"2022-06-28T19:00:57","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=145669"},"modified":"2023-03-14T15:06:02","modified_gmt":"2023-03-14T19:06:02","slug":"stock-market-valuation-and-impact-of-inflation","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/stock-market-valuation-and-impact-of-inflation\/","title":{"rendered":"Stock Market Valuation and Impact of Inflation"},"content":{"rendered":"\n

The post “Stock Market Valuation and Impact of Inflation<\/em>” first appeared on Light Finance Blog<\/a>.<\/em><\/p>\n\n\n\n

If 2022 has taught us anything, it is that our understanding of the inflationary process is woefully incomplete. Increasingly, it seems that the easy money era of the 2010\u2019s created a blind spot in the market: stable inflation and ample liquidity were taken for granted. The risk of high (indeed, very high) inflation was deeply discounted which resulted in a significant misallocation of investor capital.<\/p>\n\n\n\n

In some ways, this is understandable. Inflation had been in a steady decline for decades and in the most recent one routinely surprised to the downside. Prudence and a healthy appreciation for inflation consistently went unrewarded and was often disrespected. It was against this backdrop that investors were confronted with the most significant fiscal and monetary intervention since WWII, an epic dislocation in supply chains and war that has strangled critical commodities.<\/p>\n\n\n\n

The objective of this post to provide an analysis of inflation and market valuation. We\u2019ll find that impact of inflation on the market is highly nonlinear, but that a reasonably tight relationship exists when inflation is at extremes.<\/p>\n\n\n\n

A Puzzlingly Close Relationship<\/h2>\n\n\n\n

Stock prices reflect the expected value of future cash flows (think we all agree on this one!). It follows that low earnings yields (i.e., high PE Ratios) reflect some combination of low discount rates and\/or high expected future earnings growth. This is essentially the story of the \u201cdisruptive tech\u201d stocks that have been ubiquitous during the easy money era. However, various growth metrics are only weakly correlated with earnings yield fluctuations. Moreover, PE ratios have essentially no ability to predict future earnings growth <\/a>. These were the classic conclusions of Shiller 2001<\/a>. Indeed, analysis suggests that earnings yields are more closely associated with inflation than with real yields, nominal yields or other traditional growth metrics.<\/p>\n\n\n\n

The charts and correlation matrix below hint at this relationship. The first chart depicts the year-over-year change in CPI (LHS) and the TTM earnings-price ratio (i.e., earnings yield) (RHS). While the correlation is not perfect, there is clearly a relationship: high\/low inflation is associated with high\/low earnings yield.<\/p>\n\n\n\n

The second plot takes a slightly different view. Here I depict the normalized YoY CPI and normalized E\/P ratio to give a sense of the relative relationship. The correlation is quite tight in the first half of the series and particularly so during the inflationary 1970\u2019s and early 80\u2019s, but has been less reliable over the past twenty years.<\/p>\n\n\n\n

\"Stock<\/figure>\n\n\n\n

Source: <\/em>https:\/\/lightfinance.blog\/about-aric-lux\/, Light Finance<\/a>.
<\/em>Data from Online Data – Robert Shiller<\/a>.<\/em><\/em>
Calculations and charts: Aric Light<\/em>.<\/p>\n\n\n\n

\"Stock<\/figure>\n\n\n\n


<\/em><\/a>Source: https:\/\/lightfinance.blog\/about-aric-lux\/, Light Finance<\/a>.
<\/em>Data from Online Data – Robert Shiller<\/a>.<\/em><\/em>
Calculations and charts: Aric Light<\/em>.<\/p>\n\n\n\n

\"\"<\/figure>\n\n\n\n

Source: https:\/\/lightfinance.blog\/about-aric-lux\/, Light Finance<\/a>.
<\/em>Data from Online Data – Robert Shiller<\/a>.<\/em><\/em>
Calculations and charts: Aric Light<\/em>.<\/p>\n\n\n\n

This relationship may seem surprising because earnings yield is supposed to be a real variable. The textbook explanation is that stocks are real assets. Higher levels of inflation should be reflected in higher nominal earnings and have a negligible impact on stock prices and valuation. However, this description is not corroborated by the data.<\/p>\n\n\n\n

Further examination of the correlation matrix suggests that the connection between valuation and inflation is not easy to disentangle. Valuation appears most strongly negatively correlated with YoY CPI, but also negatively correlated with Next-12 Month CPI. This is suggestive of at least a fairly consistent relationship: high inflation is incorporated into valuation today and, should it persist, also reflected in the future. YoY CPI appears moderately negatively correlated with next-12 months real and nominal earnings growth, but next 12-months CPI is uncorrelated<\/em> with either. This second observation is harder to reconcile. Finally, both YoY CPI and next 12-months CPI are moderately negatively correlated with next 12-months nominal and real returns. The correlation is stronger for next 12-months CPI particularly where real returns are concerned.<\/p>\n\n\n\n

An Underexamined Phenomenon<\/h2>\n\n\n\n

What are the plausible explanations for this unintuitive association?<\/p>\n\n\n\n