Market Valuation and the Consumer Price Index
May 5, 2010
Last night, in response to my latest update on the valuation of the U.S. market, I received an email from a reader who asks:
How would the use of the ShadowStats "Alternate CPI" affect the graph of the P/E10? My guess is that it would push the P/E10 down to lower values because using a higher inflation rate would reduce the ratio of the current price to the average of the past earnings.
Good question, and one that I've received before. In my monthly regression analysis of the S&P Composite, I post a pair of charts showing the impact of the changes to the method of calculating the Consumer Price Index (CPI) introduced by the Bureau of Labor Statistics (BLS) in 1982. On his Shadowstats.com website, Economist John Williams calculates an "Alternate CPI" using the original BLS methodology. I use the Alternate CPI for the second chart in my regression commentary. My "Bullish" and "Bearish" labels characterize the striking difference between the two.
So let's take another look at the P/E10 ratio, an inflation adjusted measure, this time calculated with the Alternate CPI.
The standard P/E10 chart I post uses the official CPI for the inflation adjustment. The chart above shows a radically different contour to the post-1982 S&P Composite and a significantly different market valuation. This alternate version shows a much cheaper valuation, one that hit single digits in March 2009. The Tech Bubble peaked in 2000 at about the same level of over-valuation as the 1929 peak. And our 2009 valuation low was closer to the secular lows of the past, although 9.5 is still above the lows in 1921, 1932 and 1982.
My opinion is that the optimum method for calculating inflation is somewhere between the revised BLS method and the historic method preserved by John Williams. But for a long-term analysis, consistency is essential, which may lend some credibility to the alternate CPI for creating a chart of the real index price. On the other hand, government policy, interest rates, major business decisions and so much more have been fundamentally driven by the official BLS inflation data, not the alternate CPI. So it's difficult to believe that a simple substitution of the abandoned methodology would provide a more trustworthy version of the P/E10. What we have in these two versions of the P/E10 is yet another point of conflict in the perennial debate between the bulls and the bears and the inflationists and deflationists.
The last time I posted an version of the Alternate CPI adjusted P/E10 was in July 2009. Henceforth I'll make it a part of my regular monthly valuation update.
(c) Doug Short