I recently came across an interesting chart titled “Relationship Of Inflation and Price/Earnings Ratios (1900-2008).” It is from Crestmont Research and can be found at this link:
It shows the effect of inflation and deflation (as defined by the CPI) on the P/E Ratio. I think that it is worth looking at for a variety of reasons.
One of the reasons I point it out is that it provides some historical background to the Inflation/Stock Valuation topic I discussed in the article “Does Warren Buffett’s Market Metric Still Apply?”
The “inflation is good for stocks” theory is widely held. The logic says that inflation promotes higher revenue and earnings. In my opinion this logic is theoretically flawed and/or incomplete. From a practical perspective, history shows it isn’t justified, as indicated in the chart.
Furthermore, even if inflation were to appear favorable to stock prices, one has to view the stock market returns on a “real” basis.
SPX at 995.81 as this post is written