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.
While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.
Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.