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« Payroll Employment Report | Main | Interpreting the Employment Data »

July 05, 2007

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oldprof

Mike -
Thanks for the thoughtful comment. I agree that the reason inflation works so well is that it is usually aligned with interest rates.

Your point about the relationship breaking down with very low rates is a good one, something I have on the writing agenda.

When there was fear of global deflation a few years ago, the confidence in earnings expectation was even lower than it is now.

Thanks again,

Jeff

Econocator

Thanks for the kind words re Econocator, Jeff.

ps - greatly enjoyed your recent, well balanced comments on the inflation debate.

Mike

Check out the chart on the following site (7th one down, entitled 'P/E Ratios & Inflation') for some relevant repercussions of this inflation figure--and how it relates to the Fed Model.

http://www.crestmontresearch.com/content/market.htm

What it shows is that P/E ratios tend to expand over 16 only when inflation is between 2%-3% (i.e. moderate).

Inflation impacts interest rates, and higher interest rates generally correlate with lower P/E ratios. Lower interest rates, conversely, generally result in higher P/E ratios. The data for the Fed Model, however, shows LOWERING P/E ratios when rates drop from 5% or so to a lower amount, seemingly contradicting the Fed model. So why is this?

To draw a conclusion that fits the data would no doubt earn me a well-earned reprimand from the old prof, so I'll offer a hypothesis instead. Let's use the 1930s as the chief counterexample to the Fed Model. Long-term interest rates were 1%. P/E ratios were also very low. Overall, economic conditions were depressed, as were people's moods. At the end of the 1970s, long-term interest rates were in the teens, and P/E ratios were very low. Overall, economic conditions were down (though not nearly as much as in the 1930s).

The 1930s was a period of deflation and low interest rates; the 1970s, high inflation and high interest rates. I would hypothesize that the overaching depressed mood of both periods led to compressed P/E ratios. People were not hopeful about the future.

Thus when interest rates drop below a certain level (around 5%), it's likely because the outlook for the future is no longer positive, resulting in lower P/E ratios.

Over the last year, P/E ratios have once again started to expand, but they're still below the average for periods of 2%-3% inflation. It's one of the reasons among many that I'm bullish on stocks for the next few years.

Dboy

Thanks for this blog entry. I agree with your conclusions.

Dboy

oldprof

Bill--

Your (continuing) objection is duly noted!

Thanks for your comment.

Jeff

Bill aka NO DooDahs!

I only find this tolerable if I export into Word and do "edit find replace" with "CPI" for "inflation."

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