Friday, December 15, 2006

Inflation and P/E Ratio

Today it was reported November total and core CPI were unchanged from the prior month. The implications of a low inflation environment sent stock prices higher at the market open. The economy (i.e., GDP) continues to grow, albeit at a slower pace, in the third quarter: 2.2% in the third quarter versus 2.6% in the second quarter. Assuming the economy does not slip into a recession, what impact will lower inflation and slower growth have on stock valuations?

Crestmont Research, a research group that promotes hedge fund investing, notes:

"Conventional stock market wisdom has promoted a fundamental relationship between P/E ratios and interest rates. It relied upon a key assumption that inflation was positive—that deflation was not a possibility. As reflected in this chart, P/E ratios increase when inflation trends toward price stability (near 1% inflation) and P/E ratios decline when inflation trends away from price stability. The result is a "Y Curve" effect; where P/E decline into deflation despite low interest rates. This is consistent with the modern 'dividend discount model' since earnings and dividends would be expected to decline during deflation and therefore would result in lower valuations."

(click on chart for larger image)

Conflicting company and economic data continue to influence the market. Today, Black & Decker (BDK) and YRC Worldwide (YRCW), a trucking company, revised earnings guidance lower. Is this a further sign the economy is slowing; thus a weaker period for the market? Or could we be entering a period where we experience some P/E expansion partially as a result of a lower inflation environment. Determining the direction of P/E movement is important as it is one of the three components that determine equity returns:

(click on graph for larger image)

A quote in the recent newsletter from Investment Quality Trends may summarize the situation the best:
"To some market valuations are hostile. To others, market valuations offer opportunity. We will leave the discussion about the market valuations to others because we don't know how to value markets; we do know how to value stocks."

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