Inflation Expectations Change Stock Market Valuation

My comments: there is a flaw in his valuation. Equity risk premium is the earnings yield in excess of 10-year US Treasury yield, which is around 3.3%. 7.4% - 3.3% is around 4.1%. If you use inflation expectation, fine, it works out to 7.4 - 3.6 = 3.8%. Economic growth should not be included because you're double-counting. Economic growth causes inflation. There is a causal factor which overlaps. You cannot include inflation and then economic growth to calculate ERP.

Today's earnings yield should be 8.4% based on inflation expectation 4.6%. So fair PE should be 11.9x. Hence S&P500 should fall to 1,142. Already, S&P500 is at 1300 plus so you know stocks don't move in lock-step with one single valuation method.

http://seekingalpha.com/article/258261-inflation-expectations-change-stock-market-valuation


Inflation Expectations Change Stock Market Valuation by: Joe Eqcome March 15, 2011



In the past two weeks investors have been rocked by not only political and economic events but also literally by the massive earthquake in Japan sending ripples across the Pacific onto our own shores.



If that weren’t enough to convince you to be careful with regards to equities, you can throw in the coming celestial event of our sun becoming aligned with the center of the Milky Way (a 26,000 year cycle), signaling the end of the Mayan “Long Count” calendar and the end of the world on December 21, 2012 (see movie trailer here). Clearly a “sell” signal.



A More Reasoned Approach: However,for secular investors the current valuation matrix for stocks is more of a concern: the price/earnings ratio (“P/E”). The P/E can alternately be expressed as an earnings’ yield (“E/P”). Let’s for a moment assume a 2011 S&P 500 earnings estimate of $95.98 per share. Based upon the current S&P 500 valuation the earnings yield is 7.4% (13.6 times).



Let’s assume a real US economic growth rate of 2.0% and a consumer inflation expectation of 3.4% which was reported in February by Thomson Reuters/U of Michigan Sentiment Survey. The combination of real growth and inflationary expectation would add up to nominal risk free return of 5.4%. When subtracted from the current implied S&P 500 earnings yield of 7.4% it would imply an equity risk premium of 2.0%.



Getting Ugly? The University of Michigan Survey recently recorded a significant increase in consumer inflation expectation for March. Consumers’ expectation for inflation is now 4.6% up from February’s 3.4%. Now using the same numbers and imputing the new inflation expectation, the S&P 500 earnings yield should now be 8.6% (2.0% + 4.6% + 2.0%) which translates into an 11.6 price/earnings ratio. Based upon the new P/E, the S&P 500 valuation would be 1,113, or off 14.5% from its current valuation.



Take Aways: If QE2 ends when inflation is ramping-up, investment valuations could likely be negatively impacted. Who wins? Equities don’t win; bonds won’t win. If the economy continues to recover with this new inflation expectation, it’s likely that commodities and possibly high quality commercial real estate would be favored under this scenario.



The significantly higher March inflation expectation maybe just an abnormality. Likewise, the equity risk premium may already reflect higher inflation expectations. Either could justify the S&P 500’s current valuations. However, the Fed may just be unrealistic regarding inflation expectations and its ability to respond. As a result it is currently in the process of manufacturing a new bubble to be “pricked”.



Report the Facts: It’s a toss up between inflation and deflation. Inflation is clearly the lesser of two evils--however, nonetheless still evil. To paraphrase Will Rodgers, “I'm not a comedian, I just watch the government and report the facts.” (See the video