®
Market Analysis, Research & Education
A unit of Fidelity Management & Research Company
Stock Valuations
Influenced by Inflation
Low—not negative—price growth has
been optimal for investors
The link between inflation and stock valuations
The inflation environment historically has had a sig-
nificant influence on the valuations of stocks, with
investors typically willing to pay more when infla-
tion was low and less when inflation was high.
One reason this occurs is that stock prices reflect
the value of a company’s potential future earnings.
As inflation becomes higher, future earnings are
worth less due to the time-value of money, where
money in the future is worth less than money to-
day because inflation erodes purchasing power.
Higher inflation also may coincide with higher and
possibly rising interest rates, which can be detrimen-
tal to corporate borrowing and economic activity.
High inflation often led to lower valuations
Using the price-to-earnings (P/E) ratio as the valuation
measure (trailing 12-months earnings), the U.S. stock mar-
ket’s average P/E ratio was 17.7 from 1948 through 2010.
When inflation was higher during this period (1948-
2010), the average market valuation (P/E ratio) tended
to be lower (see Exhibit 1, above right). Periods of very
high inflation—when the consumer price index (CPI)
increased more than 6% in a year—were accompa-
nied by well-below-average P/E ratios of about 10.
Low inflation has coincided with elevated valuations
When annual inflation rates were below 2%, stocks had
an above-average valuation (P/E ratio of 22). Valuations
generally were above average when inflation stayed
SEP 2, 2010
Exhibit 1: Historically, periods of low inflation have coincided with above-average market valuations, and vice-versa.
Average S&P 500 Price-to-Earnings Ratio in a Given Inflationary Environment
(1948-2010)
25
Price-to-Earnings Ratio
20
15
10
5
0
< 2% 2%-3.99% 4% -5.99% > 6%
Inflation Level
Price-to-earnings ratio is calculated using the end-of-quarter price of the S&P 500 Index divided by the trailing 12-month earnings on the index. Inflation
defined as the year-over-year percentage change in the Consumer Price Index.
[i] The data shown when U.S. inflation was less than 2% in the chart above includes a few periods of deflation (falling prices).
Source: Standard and Poor’s, Bureau of Labor Statistics, Haver Analytics, FMRCo. (MARE) as of 8/31/10.
Past performance is no guarantee of future results. You cannot invest directly in an index. Investment decisions should be based on an individual’s own
goals, time horizon, and tolerance for risk. The S&P 500, a market-capitalization-weighted index of common stocks, is a registered service mark of the
McGraw-Hill Companies, Inc. and has been licensed for use by Fidelity Distributors Corporation.
below 4%. However, investors should keep in mind that Thus, given the low current level of inflation and
P/E multiples generally were below average during both trailing and forward-looking measures of
the few rare deflationary periods in the U.S. economy,i earnings, the stock market’s current valuation
signaling that low—but not negative —consumer is somewhat below historical norms.
price growth has been most desirable to investors.
Today: Low inflation and below average stock The Market Analysis, Research and Education (MARE)
market valuations group, a unit of Fidelity Management & Research Co.
As of July 2010, year-over-year inflation stood at 1.3%, (FMRCo.), provides timely analysis on developments in
while the S&P 500’s P/E ratio (using trailing 12-month the financial markets.
earnings) was 15.6 as of August 2010—somewhat
below the index’s historical average (17.7).
Brokerage products/services and workplace savings plan products/services
offered directly to investors and plan sponsors provided by Fidelity Brokerage
Using earnings forecasted over the next 12 months (to Services, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917.
August 2011) the market’s P/E ratio was 14.1 as of the end Investment and workplace savings plan products and services distributed
through investment professionals provided by Fidelity Investments Institution-
of August—also below the index’s long-term average. al Services Company, Inc., 100 Salem Street, Smithfield, RI 02917. #560171.1.0