In May, the Consumer Price Index (CPI) rose at its fastest pace in more than a year. This may be an indication inflation has bottomed, or it was just a momentary spike. Whatever inflation does, it is a good time to measure stock market valuation and inflation. This post has been updated from our original post on December 18, 2013.
In previous posts, I have argued why using the Big Mac Index may be a good alternative to measure inflation rather than using the Consumer Price Index (CPI). In this post, I extend the research further to include a comparison with valuations in the stock market.
Expanding on work from Ed Easterling and Doug Short, I compare the price-to-earning ratio 10 year (P/E10) to inflation as measured by the Big Mac Index. I have chosen to use the P/E10, or cyclically adjusted price earnings ratio (CAPE), because this valuation metric is more highly correlated to movements in the market than the normal P/E ratio that uses forward earnings.
To begin, let’s start with Ed Easterling’s work with in P/E Ratios and Inflation. In Easterling’s work there are two notable findings:
- P/E ratios increase when inflation is near 1%
- This increase is consistent with the dividend discount model valuations
The P/E relationship to inflation is predicated on stable prices. That is, when inflation as measured by CPI is around 1%, P/E ratios are at their highest. P/E ratios decline when there is deflation. They also decline when there is greater inflation, above 1%, which Easterling has coined as the “Y Curve.”
Easterling believes that this is consistent with the dividend discount model or discounted cash flows, because dividends and earnings decline with inflation. With higher inflation, company’s profit margins are not as strong, because it is difficult to raise prices as fast as the underlying commodities’ price increases. Earnings are also not as strong in an environment when prices are increasing. Therefore, a stable price environment benefits stock price valuations.
Inflation Sweet Spot
Short dug into this work and noted a “sweet spot”—the range that has supported the highest valuations—is between approximately 1.4% and 3%.
As Short noted in his most recent update, “The latest P/E10 valuation is 24.9 at a 1.9% year-over-year inflation rate, which is in the sweet spot mentioned above.”
So, there is clear evidence that higher valuations are supported by stable and relatively low inflation.
Big Mac “Y Curve”
In the graph above, the CPI is indicated by dark blue circles, and the Big Mac is identified with baby blue diamonds. The Y Curve still exists, but there are a couple things to note.
- First, due to fewer years of calculation, valuations do not go below 15 times 10-year earnings. This is a result of the Bull Market that began in the 1990s and the Big Mac Index first being reported in 1986.
- The more interesting observation is that the baby blue diamonds are more dispersed. The dark blue circles (CPI) are in a tighter configuration. It causes me to ponder whether CPI is capturing the inflation that people are experiencing. Additionally, I question whether the balance of items and the smoothing that is done by the Bureau of Labor Statistics to understand the long-term impact of inflation is under reported and giving individuals a false sense of security about inflation.
These findings lead to a point that beacons further analysis: comparing the components of CPI against the Big Mac. What would cause the greater dispersion?
Sweet Spot between Two Buns
OK, the Big Mac has three buns, but it did not fit the title. My intent here is to observe the market’s highest valuations when the Big Mac’s price increases at different rates.
I corroborated Short’s finding about valuations and CPI inflation, “The range that has supported the highest valuations, is approximately between 1.4% and 3%.” As for the Big Mac Index, the finding was the same: The highest P/E10 was a Big Mac inflation of between 2% and 3%. P/E10 declines below and above a Big Mac inflation of 2% to 3%.
However, there were outliers with less than 0% inflation and between 5% and 6%. During deflation and the higher inflation, P/E10 was 33.8 times earnings and 31.2 times earnings, respectively.
At this point, I attribute this to the lack of data points. We only have four points when the Big Mac declined in price and three points when Big Mac inflation was between 5% and 6%. Two of the four points when the Big Mac declined in price were in 1999, when we now know that the stock market was on a buying frenzy and way too high.
On the higher side, between 5% and 6% Big Mac inflation, the three points came within seven months of a significant stock market decline. In the fall of 1998, stock prices declined as the Asian Currency Crisis swept through the world. Big Mac prices climbed over 5% seven months before the crisis. Prices for the Big Mac then climbed by more than 5% seven months again before the stock market declined in November 2007. The last growth rate above 5% was last July.
The most recent reading of inflation measured by the Big Mac saw a three month decline of 4.0% and a year-over-year decline of 2.4%. CPI increased 0.7% over three months and is up 2.1% year-over-year. This would say that valuations based on PE10 could come down off their peaks. If we see further declines in the Big Mac Index, we would expect overall valuations to decline from the current lofty stance of 25.4 times PE10.
Declines on the Horizon?
Does this mean that stock prices are soon to decline? I don’t know, but it is worth continuing to observe. I am also looking at updating the analysis quarterly. This will increase the data points and give us more accurate statistical analysis.
Completing the same analysis Short did with CPI inflation, we see from the graph above that there is a higher range of Big Mac inflation as the baby blue diamonds can be seen further to the right. We also see the three baby blue diamonds to the left that look more like outliers at the higher valuations.
The Big Mac continues to be my inflation metric of choice. It is readily available and purchased daily with “Over a billion served.” Consequently, looking at stock market valuations in context to Big Mac prices has some validity. I will continue to monitor and see if my observations hold.