Here is a rather different look at the pattern of cyclical P/E10 ratios that form the basis of my monthly valuation update Is the Stock Market Cheap?

Instead of the usual chronological sequence of ratios, the scatter diagram below plots the monthly ratios according to the annualized inflation rate on the horizontal axis. I've set vertical gridlines at 4% intervals and marked the average (arithmetic mean) P/E10 for each 4% vertical band.

The table below shows the valuation high and low for each 4% range as well as the average and median. We also see the number of months and percent of the total time in each range. The current P/E10 is significantly above the 16.4 average (arithmetic mean) for P/E ratios over the nearly 13 decades of market history in the chart. But it is only moderately above average when the inflation rate is in the 0 to 4% range.

On the other hand, low inflation is no guarantee of high cyclical P/E ratios. There are a significant number of data points in the inflation sweet spot that are below the average P/E10. And then there's that strange loop floating at the top of the 0 to 4% range.

What's the Loop?

Notice that conspicuous loop at the top of the 0 to 4% vertical band. Here is an alternate chart version to which I've added lines to the scatter points to show the chronology of the period from May 1997 to March 2003. The result illustrates the appropriateness of the metaphoric phrase Tech Bubble.

As we can see, the Tech Bubble was an obvious valuation outlier — one that was in part made possible by the low interest-rates of the Great Moderation. It's difficult to imagine such lofty cyclical P/Es in a time of high inflation or deflation. On the flip side, without the Tech Bubble, the average P/E10 for the 0 to 4% inflation range would be about 15.1 — which would put the current P/E10 even further into overvaluation territory.

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This post previously appeared at DShort.com >