Market Valuation, Inflation and Treasury Yields: Clues from the Past
Guest post by Doug Short.
Here is a follow-up on my monthly valuation updates. When I started including the Crestmont P/E updates in my monthly valuation reporting, I developed a scatter graph to illustrate the correlation between the Crestmont P/E and inflation.
My monthly valuation updates of the P/E10 ratio (Is the Stock Market Cheap?) have not included a comparable scatter graph, so I spent some time today crafting the first chart below. I’ve included some key highlights: 1) the extreme overvaluation of the Tech Bubble, 2) the valuations since the start of last recession, 3) the average P/E10 and 4) where we are today.
The inflation “sweet spot”, the range that has supported the highest valuations, is approximately between 1.4% and 3%. For example I’ve highlighted the extreme valuations associated with the Tech Bubble arbitrarily as a P/E10 at 30 and higher. The chronology of the orange “bubble” on the chart is a clockwise loop of 56 months starting at the 6 o’clock position. The P/E10 was 31.3 and the annual inflation rate for that month, June 1997, was 2.30%. The average inflation rate for the loop was 2.41%. The P/E10 peak of 44.2 in December 1999 was accompanied by a 2.68% annual inflation rate. Two months later the inflation rate topped 3% at 3.22%. The right side of the loop shows what happened thereafter. The ratio slipped below 30 for two months (the tail at the bottom of the loop) before its final three-month swan song in the 30+ range.
And speaking of that 30 threshold for the P/E10, prior to the Tech Bubble, only two months in history had a ratio above 30: They were 31.5 and 32.6 in August and September of 1929, just before the Crash of 1929.
P/E10 and the 10-Year Treasury Yield
A question I’m often asked is whether a valuation metric such as the P/E10 has any merit in a world with Treasury yields at current levels. Investors who require portfolio growth might indeed be motivated to disregard historic indicators that warn of an overvalued market. But what does history show us about the correlation between the P/E10 and the 10-year constant maturity yield? The next scatter graph offers some clues.
Essentially we are in “uncharted” territory. Never in history have we had 20+ P/E10 ratios in the low 2% and lower range. The closest we ever came to this in US history was a seven-month period from October 1936 to April 1937. During that timeframe the 10-year yield averaged 2.67%, about 100 basis points above where we are now. How did the market fare? The S&P Composite hit an interim high (based on monthly averages of daily closes) in February 1937. The index plunged 44.9% over the next 15 months.
If we look to the Dow daily closes during that period, the index hit an interim high on March 3, 1937 and fell 49.1% to an interim trough on March 31, 1938 — 13 months later.
What can we conclude? As I said above, we’re in “uncharted” territory. Fed easing will probably keep yields in the basement for a prolonged period, thus promoting a risk-on skew to investment strategies. On the other hand, we could also see exogenous shocks from the euro zone or Asia that could give investors second thoughts about equities.
We are indeed living in interesting times.