May 2020: Market Valuation, Inflation and Treasury Yields
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 on 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 May 28, it was at 1.58%.
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 last recession, 3) the average P/E10 and 4) where we are today. The inflation figure in the highlighted box is YoY. We have also highlighted the inflation "sweet spot" in green, which we discuss below. Note on inflation: the inflation figure is extrapolated for May based on the previous two months. The Census Bureau's May CPI figure does not come out until mid-month. These extrapolated figures are then updated to the current CB number when released.
The inflation "sweet spot", the range that has supported the highest valuations, is approximately between 1.4% and 3%. See, for example, the highlighted extreme valuations associated with the Tech Bubble arbitrarily as a P/E10 of 25 or so and higher.