Tuesday, June 17, 2008

Inflation and stock market

WSJ article looks at the relationship between inflation and stock market performance:
Based on the S&P 500's current multiple of 16.8 times earnings over the past 12 months, according to Thomson Reuters, investors are anticipating modest inflation. Since 1950, in periods when inflation ran between 2% and 4% (as it has through much of this decade), stocks traded at an average price/earnings ratio of 17.4, according to Strategas Research Partners. But in a 4% to 6% inflation environment, the average P/E ratio dropped to 14.7.
Last Friday, the Labor Department reported that the consumer price index for May was 4.2% higher than a year earlier. If inflation rises closer to 6%, it could drive the market's P/E ratio closer to 14. Currently, earnings for the S&P 500 companies are expected to come in at about $92 a share, and a three-percentage-point contraction in P/E multiples means fair-market value for the S&P 500 index drops by 276 points.
The reason that P/E ratio is lower in a higher inflation environment is because the real earnings, or the inflation adjusted earnings are lower than the reported earnings. If you look at real earnings, P/E ratio actually didn't change much.