Thursday, March 1, 2012

The Inflation-P/E Ratio Connection in One Chart

The old rule of thumb was the "rule of 20": If broad market P/E plus inflation was less than 20 equities were undervalued. That is a very rough guide. You can massage the numbers for whether inflation is rising or falling and for the implicit risk premium i.e. pretty much make it say whatever you want.

In last week's "Inflation Expectations Percolating Higher …" I said:
A subject near and dear. The sweet spot for P/E ratios is 1.00- 2.00% annual CPI inflation. As you move away from that in either direction multiples drop off pretty fast, to the point that equities are not an optimal investment. You won't believe what the best investments for inflation in the 8-12% and greater than 100% ranges are. I'll write about them if we ever go Weimar....
That is a tighter range than I mentioned three weeks earlier in "The S&P/Inflation Expectations Correlation (SPY)":
A major caveat for investors trying to hedge inflation with equities: they aren't that correlated once inflation goes above 4% or so. 0-to-4% is the sweet spot. Above 4% you don't want services companies, manufacturers with tangible assets are the place to be....
Since 0-4% brackets 1-2% I go with the quote attributed to Lady Astor:
In grammar as in life the male embraces the female.
[so 0-4 embraces... long way for a short analogy -ed]

Here's Crestmont Research via dShort:
...Because inflation is a key driver for direction of P/E multiples, I occasionally update this chart twice a month if the mid-month release of the Consumer Price Index marks a significant change in the annualized rate of inflation.


We like Crestmont.
[and dShort -ed]