The stock market has just finished an exuberant first half, leading to worries that stock prices are too high. But a bank economist says low inflation can contribute to higher valuations.
The Standard & Poor's 500 stock index rose 19.5% in the first six months of the year, a gain that not so long ago would have been regarded as more than ample for an entire year.
The S&P 500 stocks currently trade around 20 times trailing earnings, which is near the top of their 50-year range. Yet stocks seem "only slightly" overpriced at this point, said Sung Won Sohn, chief economist at Norwest Corp., Minneapolis.
"Inflation has a lot to do with the price-to-earnings ratio," he pointed out. "History shows that the multiple increases as inflation decelerates, since the quality of earnings improves."
In short, as long as the inflation picture remains good, the market's price multiple will continue to trend up, said Mr. Sohn, who offered an illustration of why the link with inflation is so strong.
When inflation in this country was high and rising during the 1970s and early 1980s, the quality of corporate earnings was distorted, he said. Valuation of inventories inflated profits and forced the payment of higher taxes and dividends, hurting cash flow.
"Accounting profits were going up, but cash flow was getting worse," he said. "When the inflation rate comes down, the exact opposite happens."
That helps to explain the great bull market of the past decade, as inflation has receded, as well as the bear market that preceded it.
The current high valuation of the S&P 500 is also due to the 50 largest stocks in the index. "These popular large capitalization stocks distort the valuation for the rest of the pack," he said.
The price-to-earnings multiple of other market indexes, such as the Russell 2000, which measures small-cap and mid-cap stocks, is not high, he said.
"The market is exuberant, but not irrational," said Mr. Sohn. As portfolio managers see it, earnings gains of 10% to 12% in a low inflation environment are very powerful drivers of stock prices.
Federal Reserve Chairman Alan Greenspan stirred much comment last December when he asked rhetorically during a speech whether "irrational exuberance" was a factor in the market.
"Yes, the stock market is soaring, but not irrationally," said Edward Yardeni, chief economist at Deutsche Morgan Grenfell Inc. In the past five years, S&P 500 earnings are up 148%, and the S&P index is up 91%, he noted.
Among the reasons is that corporate net interest expenses have been flat so far in the 1990s, boosting the bottom line. That trend should continue, he said, "because corporate cash flow is so strong."
He said S&P 500 earnings per share should rise 11% this year to $45.50, powered by innovation and productivity gains. And so, right now, he believes the stock market is advancing on "profits-led exuberance."
