S&P500 Shiller PE Vs Inflation: July 2023 Update

The latest inflation data for June indicates a significant decrease in inflation across various components, which has led to a surge in market indexes. The current conditions are favorable for a market rally. On one hand, the economy is stable, with record-low unemployment rates and expanding GDP. On the other hand, inflationary pressures are easing, resulting in increased asset valuations across the board.

Now, the question arises: what can we expect for future valuations, and is there a way to estimate them? One approach is to plot valuations against inflation. The following graph illustrates the relationship between the S&P500 Shiller PE ratio and core inflation, highlighting both the past inflationary cycle of the 1970s and the current cycle.

The current cycle bears striking similarities to the 1970s cycle in various aspects, such as core inflation, unemployment rates, stimulus measures, and eventual peak inflation. During that time, valuations exhibited a certain pattern in response to inflation, and the present cycle has followed a similar trajectory. By projecting valuations today using the reference from the past, it’s likely that valuations will soften before experiencing another surge.

Currently, valuations measured against core inflation are elevated compared to historical data. This indicates that the market anticipates no decline in earnings and expects a 2% inflation rate in the future. However, any deviation from these assumptions is likely to trigger a market correction. It is advisable to closely monitor the upcoming quarterly earnings as they will determine whether the expectation of no earnings decline remains valid.

– Airtham Research