January 2022: Market Valuation, Inflation and Treasury Yields

This article was originally written by Doug Short. From 2016-2022, it was improved upon and updated by Jill Mislinski. Starting in January 2023, AP Charts pages will be maintained by Jennifer Nash at Advisor Perspectives/VettaFi.

Note: The charts in this commentary have been updated to include the latest monthly data.

Our monthly market valuation updates have long had the same conclusion: US stock indexes are significantly overvalued, which suggests cautious expectations for 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 January 31, 2023, it was at 3.52%.

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 COVID recession; 3) the average P/E10; and 4) where we are today. The inflation figure in the highlighted box is YoY. I have also highlighted the inflation "sweet spot" in green, which I discuss below.

Note on inflation: The inflation figure is extrapolated for last month is based on the previous two months. The Census Bureau's CPI figure does not come out until mid-month for the previous month. These extrapolated figures are then updated to the current CB number when released.

P/E10 and Inflation Scatter

The inflation "sweet spot", the range that has supported the highest valuations, is approximately between 1.4% and 3%. We highlighted the extreme valuations associated with the tech bubble, which we chose arbitrarily as a P/E10 of 25 and higher. We are still in that range.