Navigating Inflation from Up Here

February 10, 2022 | Rodrigo De La Peña Alanis, Associate Research Analyst

Column chart showing price-to-earnings ratio per CPI tranche. Chart subtitle: Historically when inflation has been this high, the S&P 500 has traded at an average 12X P/E. Chart description: Y-axis shows Average S&P 500 P/E, ranging from 0 to 25. X-axis shows CPI Tranches in 8 dark purple column categories: -2 to 0% (column at 15.8), 0 to 2% (column at 18.8), 2 to 4% (column at 18.5), 4 to 6% (column at 15.7), 6 to 8% (column at 12.1), 8 to 10% (column at 9.8), 10 to 12% (column at 9.0), and 12 to 14% (column at 7.9). Green outline shows January 31, 2022 data; within the 6 to 8% category, the S&P 500 traded at 23.7x trailing earnings. Chart sources: Bureau of Labor Statistics, Bloomberg; data ranges from January 31, 1954 to January 31, 2022.

Despite year-to-date turbulence, equity markets remain near all-time highs. While company earnings have more than recovered from the lows of early 2020, valuation multiples are also still well above pre-pandemic levels. Our chart of the week looks back at historical trailing P/E levels of the S&P 500 in different inflationary environments. Historically, in months when consumer prices were up between 6% and 8%, the S&P 500 traded at an average 12X earnings, below its long-term average of 17X. As of January 31st, the S&P 500 traded at 23.7X trailing earnings.

With most of these data points coming from the 1970s, this is more of an interesting anecdote than a prescriptive playbook, but does directionally make sense. Higher inflation tends to lead to rising interest rates, as the Federal Reserve looks to maintain price stability. Higher interest rates, in turn, put downward pressure on valuations, as the discount rate used to value a stream of future earnings increases. Companies whose value is largely derived from future growth in earnings see a pullback in the multiple investors are willing to apply to current earnings.

The Fed’s increasingly hawkish tone has already led to a meaningful correction in multiples, with potentially more volatility to come. While perhaps unnerving, the change in backdrop is creating opportunities for stock pickers. Active long-only and long/short managers should be better positioned to navigate market headwinds and add value for investors. While we of course do not have a crystal ball, we are looking forward to active managers hopefully capitalizing on an improved opportunity set this year.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Rodrigo De La Peña Alanis
Associate Research Analyst

Get to Know Rodrigo

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

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