We have frequently noted the inverse relationship between rising inflation and interest rates, on the one hand, and lower valuation multiples, on the other. The Rule of 20 has been a simple yet effective gauge of determining whether the market is rich or cheap. Since 1970, the sum of the market’s PE and the year/year change in the CPI has averaged 20. Significant time above that figure warrants caution, while a sum below 20 represents the emergence of some value. Today, the sum of the forward multiple on the S&P 500 and the CPI is 27.8 (21+6.8), more than two standard deviations above the long-term mean and resting at levels that exceed the go-go years of the late 1960s and rivaling those seen at the height of the dot.com bubble. Even if inflation were to halve from current levels, the market would still be deemed expensive by this measure. It does seem inevitable that valuation multiples will need to decline to remain sustainable in the context of structurally higher inflation and interest rates.
Source: Strategas Research Partners