As a result of the recent global financial crisis and subsequent risk of deflation, much of the world is currently awash in liquidity. While this is likely to continue until the economy moves into a solid recovery mode, one concern on the part of many investors is whether rising inflation will result when economic growth encounters “cheap money.” U.S. Federal Reserve Chairman Ben Bernanke actually devoted a talk he gave two weeks ago to this topic, describing how the Fed will withdraw liquidity with growth in order to avoid inflation but not choke-off recovery due to rapidly rising interest rates.
That is a tough balancing act and many investors remain concerned—primarily about the risk of higher inflation and how it might affect the stock market. But asking the general question “How do stock markets respond to inflation?” is a lot like asking “How do people deal with a financial setback (or windfall)?” The answer in both cases is “It depends”—on a lot of situational factors and other considerations. There is no single or simple answer.
That said, in this week’s Weekly Market Update, we will attempt to provide some insight by taking a very specifically defined measure of stock market value—the Price to Earnings Ratio on the Standard & Poors 500 Index®—and analyzing how it has performed relative to one specifically defined measure of inflation, changes in the Consumer Price Index (CPI). We used the S&P 500 Price to Earnings Ratio because it is a popular measure of how much value (in terms of aggregate stock prices) investors place on each dollar of earnings companies have generated.
In summary, here’s what we’ve done:
- We gathered quarterly data from 1946 to 2009 on changes in the urban measure of the Consumer Price Index (or CPI-U), and quarterly values for the S&P 500 Index Price to Earnings Ratio (as supplied by Standard & Poors) based on the trailing 12 months of earnings by the 500 companies that comprise the index.
- We created a “scatter plot” (a kind of graph—see below) that plots the trailing S&P 500 Price to Earnings ratio versus the corresponding change in the CPI for all 255 quarters between the first quarter of 1946 and the third quarter of 2009 to see if any relationship is apparent between these two factors.
- We also categorized each of the 255 past quarters into defined “buckets” or levels of inflation (e.g. 0-1%, 1-2%, etc.), and then calculated and plotted the median S&P 500 Price to Earnings Ratio for each level of inflation (again, see below).
The “Scatter Plot Analysis” Results
Based on the scatter plot, we can make the following general observations about the historical relationship between quarterly Price to Earnings Multiples for the S&P 500 and changes in the CPI-U over the 1946 to 2009 period:
- Periods with lower rates of positive inflation (less than 5%) correspond to a wide range of Price to Earnings multiples ranging from 5 to over 35. In other words, within this limited range, inflation does not appear to be an important factor in explaining Price to Earnings Ratios for the S&P 500.
- Periods with higher rates of positive inflation (greater than 5%) correspond to both a narrower and lower range of Price to Earnings multiples. While other factors could be involved, since 1946 inflation rates higher than 5% correspond to a lower range of Price to Earnings Ratios in the range of 7 to 17.
- Periods of negative inflation have been somewhat rare since 1946. As a result, their impact on Price to Earnings Ratios is difficult to summarize.
Source: Standard & Poors and the Bureau of Labor Statistics
- By limiting the y-axis to a maximum value of 40, all three data points from the three quarters of 2009 where the Price to Earnings Ratio exceeded 100 with slightly negative inflation are not shown in the plot
- The black line shown is meant to visually convey the general trend in the data scatter
The “Bucket Analysis” Results
Using the same quarterly data from 1946 to 2009, we collected the results for Price to Earnings Ratios by defined buckets or levels of historical CPI-U inflation. In the bar chart below, we plot the median (middle value) Price to Earnings Ratio for each bucket/level of inflation. And in the data table below the bar chart, we illustrate the number of quarters included in each bucket (the Count) as well as the Minimum and Maximum value for Price to Earnings Ratios in each bucket.
Source: Standard & Poors and the Bureau of Labor Statistics
Based on this bar chart, we can make the following general observations about the relationship between historical quarterly Price to Earnings Multiples for the S&P 500 and levels of change (1% increments or buckets) in the CPI-U.
- The highest median Price to Earnings Ratios for the S&P 500 have occurred in a range of inflation between 1% up to 6%, where the median values have been above approximately 16.
- Above 6% inflation, the Price to Earnings Ratios decline substantially.
- In the range of very low (less than 1%) inflation or deflation (negative changes in the CPI-U), Price to Earnings Ratios are both lower than in low inflationary environments and (in the case of deflationary periods) highly variable based on the maximum and minimum values
We titled this Weekly Market Update “Stock Market Performance and Inflation”. Then we described a very specific analysis limited to one index representing stocks (the S&P 500), one measure of stock market performance (a measure of value using the quarterly Price to Earnings Ratio based on trailing 12 months earnings) and one measure of inflation based on a measure of the Urban Consumer Price Index (CPI-U) as reported by the U.S Bureau of Labor Statistics.
Using both the scatter plot and bucket analyses, we found historically that lower levels of inflation are not a key determinant of the Price to Earnings Ratio for the S&P 500. In fact, the bucket analysis shows that the highest median values of this ratio occur in the range of 1-4% annualized inflation. However, beyond this level of inflation, both the scatter plot and bucket analyses agree that higher levels of inflation can reduce the aggregate Price to Earnings Ratio of the S&P 500.
But why? According to academic research on this topic, the following reasons have been proposed:
- Higher levels of inflation are typically associated with periods of longer-term and more general economic challenges which require resolution before a foundation of sustainable economic growth can occur.
- Higher levels of inflation distort interpretation of company financial statements. A company might exhibit growing earnings per share, but in a higher inflationary environment, how much of this is due to real/sustainable gains in productivity, market share and other key factors.
- Inflation levels beyond 5-6% are often associated with investor concerns about run-away (or unexpected) inflationary levels. While many may view upwards of 3 to 4% inflation manageable by the Fed (and forecastable), levels of inflation beyond this suggest to investors that inflation is getting out of control and is no longer forecastable.
Keep in mind the following caveats when interpreting these charts, data and our observations:
- The S&P500 Index is only one approximation for the “stock market”. Its focus is on U.S. large cap blend (value and growth) companies. Any of the general observations we’ve made for this index may not apply to other indexes.
- Individual companies within the S&P 500 Index will perform very differently in low inflationary, high inflationary and deflationary environments depending upon their particular circumstances including industry affiliation and company strategies.
- The S&P 500 is a passive investment. Active managers with insights as to how inflation can affect individual company performance may do much better in any kind of higher inflationary environment through effective stock selection.
- Inflation as we’ve defined it by changes in the CPI-U index is also only one (and a U.S.) measure of inflation at the consumer level. There are many other measures of inflation and each impacts individual companies in different ways.
- The S&P 500 is an index representing 500 companies whose membership changes over time.
- Past performance is no guarantee of future results.
S&P 500 Index: A market value-weighted index of the stocks of 500 publicly traded U.S. companies chosen for market size, liquidity, and industry group representation that are considered to be leading firms in dominant industries. Each stock’s weight in the index is proportionate to its market value. Created by Standard & Poor’s, it is considered to be a broad measure of U.S. stock market performance. It is not an investment product available for purchase. Nearly all index funds and exchange-traded funds claiming to provide an investment in the S&P 500 do so by investing in a smaller group of companies that mimic or track this overall index in order to keep costs low.
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