December 2020: Market Valuation, Inflation And Treasury Yields

Our monthly market valuation updates have long had the same conclusion: US stock indexes are significantly overvalued, which suggests cautious expectations on investment returns. In a "normal" market environment -- one with conventional business cycles, Federal Reserve policy, interest rates, and inflation -- current valuation levels would be a serious concern.

On August 4, 2020, the 10-year Treasury yield hit its all-time low of 0.52%. As of December 31, it was at 0.93%. Let's take another look at the popular P/E10 valuation metric.

Here is a scatter graph with the market valuation on the vertical axis (log scale) and inflation on the horizontal axis. It includes some key highlights: 1) the extreme overvaluation and irrational period of the Tech Bubble, 2) the valuations since the start of last recession, 3) the average P/E10 and 4) where we are today.

P/E10 and Inflation Scatter

The inflation "sweet spot", the range that has supported the highest valuations, is approximately between 1.4% and 3%. See, for example, the highlighted extreme valuations associated with the Tech Bubble arbitrarily as a P/E10 of 25 or so and higher.

The latest P/E10 valuation is 33.8 at a 1.20% year-over-year inflation rate, which is below the sweet spot mentioned above and the P/E10 valuation is in extreme valuation territory.

P/E10 and the 10-Year Treasury Yield

A common question is whether a valuation metric such as the P/E10 has any merit in a world with Treasury yields at current levels. Investors who require portfolio growth might indeed be motivated to disregard historic indicators that warn of an overvalued market. But what does history show us about the correlation between the P/E10 and the 10-year constant maturity yield? The next scatter graph offers some clues. The horizontal axis has been switched to the 10-year yield. The chart uses a log scale to better illustrate the relative yields values.

On the recommendation of Ed Easterling of Crestmont Research, we have adjusted the chart to begin in 1960. Prior to the 1960s, bond yields did not respond consistently to changes in the inflation rate.

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Disclosure: None.

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