P/E Ratios & Inflation

Conventional stock market wisdom has promoted a fundamental relationship between P/E ratios and interest rates. It has relied upon a key assumption that inflation is positive. As reflected in this chart, P/E ratios increase when the inflation rate trends toward price stability (near 1% inflation) and P/E ratios decline when the inflation rate trends away from price stability. The result is a “Y Curve” effect, where P/E declines into deflation despite low interest rates. This effect 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.