To explain why higher inflation drives down P/E, let’s first think about the phenomenon of inflation itself. We talk about inflation whenever prices rise, but not all price increases are inflation. When the price of one thing or a few things increases, that’s just a price increase. When the aggregate price level across the economy rises, that constitutes inflation. Inflation occurs when the federal government prints more money than the value of goods in the economy. The result is that the prices of goods and services adjust upward to reflect the loss of monetary value.
That’s where interest rates come into the picture. Interest rates help to offset the loss of value due to excess money creation. That’s also why interest rates generally increase as inflation rises and fall as inflation declines. It is also why bond prices and yields rise and fall as the expected inflation rate changes.
To illustrate, bonds are financial securities that pay interest over time. A $100 bond with an interest rate of 5% pays $5 per year throughout its term. As long as market interest rates remain at 5%, then the bond will be worth $100. But if inflation rises and market interest rates go to 10%, the bond will no longer be worth as much. New bonds, with a market rate of 10%, will be worth $100, but a 5% bond will trade at a discount to compensate for its lower interest rate (up until the bond matures).
The key point is that rising inflation drives bond prices lower. Conversely, falling inflation makes those bond payments worth more since new bonds will pay lower interest payments. Bond prices and inflation, in general, are inversely related.
Now, let’s consider the stock market. Stocks are also financial assets. They often pay dividends with a portion of earnings and retain the balance of earnings to support the company’s operations. As a result, stocks are financial assets with a value today based on future cash flows. And just as with bonds, when inflation rises, the value of stocks today falls to reflect higher market rates.
We measure the value of stocks using the ratio of market price to current earnings (the price/earnings ratio, or P/E). When inflation rises, stock prices fall–so the ratio of P/E falls too. This enables new buyers of stocks to pay a lower price to receive a higher return to compensate for inflation. Conversely, falling inflation generally drives higher stock prices and P/E.
When the inflation rate falls into deflation, there’s another financial principle that causes P/E to fall. But we’ll save that for another discussion.
Note the graph below. When blue line inflation is high (red circles), the green line P/E is below average (yellow arrows). Whenever inflation is low (green check marks), note that green line P/E is well above average. (There’s one good incidence of deflation and lower P/E in the 1930s.) Inflation and P/E do bounce around a bit, yet the relationship follows the financial principles described above. Some people like the chart below (generally presented without the markings), and others prefer the one called The Y Curve Effect. Both charts are available on the Crestmont Research website in the Stock Market section.
