The Market Rally & Inflation Expectations

One way to think about the market rally may be just to focus on inflation. Most objective political observers say that president Trump’s fiscal proposals would create far larger deficits than the GOP has been historically willing to support and thus would generally be expected to be inflationary. The market got this right away with the biggest change in forward economic expectations since the election being inflation expectations, not real interest rates or growth (although the outlook for these has picked up as well).

Here’s the market implied outlook for inflation over the next five years.

The red arrow shows the bottom in inflation expectations occurred just as the stock market bottomed in February of 2016. The green arrow points to the election. While inflation is usually viewed as a negative, it is generally thought that some inflation, about 2% or a bit more, is a good thing. Historically the PE ratio on the S&P 500 has been highest when inflation is in this sweet spot.

Source: Crestmont Research

Notice that while the current market PE of 22x is above the long-term average, it is right in line with the average PE ratio seen during periods with inflation in the 2%-3% sweet spot. At Ensemble Capital, we don’t spend a lot of time trying to determine the appropriate valuation for the market as a whole but instead focus on the specific portfolio of companies we own. So we’re not arguing here that the current market is worth 22x earnings (it could be worth more or less), we’re just pointing out that the behavior of inflation expectations over the last year have a lot to do with understanding the market rally.

It is easy to think of the market rally as a reaction to the full range of president Trump’s policy proposals. But at the end of the day, market values are driven more by core economic metrics such as inflation, real growth rates, and real interest rates than the wide range of other policy issues that grab the attention of Washington. While these other issues may well be more important to us as citizens than issues like inflation and GDP growth, it is these core economic metrics that drive the stock market.

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