Alternative Wealth Discount (Inflation) Rate
Posted in Economic Indicators
December 15, 2006
The wealth discount (inflation) rate is arguably a critical decision input for investors, who ought to demand that their stock holdings earn profits at a rate somewhere above the inflation rate. Does one of the alternative measures of the inflation relate more strongly to the S&P 500 operating earnings yield (E/P) than the others? Using monthly data for December 1989 through November 2006 (203 months), we find that…
The different alternative inflation rates considered are:
- The non-seasonally adjusted monthly inflation rate from the Bureau of Labor Statistics (BLS);
- The seasonally adjusted monthly inflation rate from BLS;
- The core (less food and energy) monthly inflation rate from BLS;
- The inflation rate based on the Personal Consumption Expenditures: Chain-type Price Index (PCEPI); and,
- The trimmed mean PCE inflation rate.
The following chart compares the various inflation rates to the earnings yield. We omit the seasonally adjusted inflation rate because it follows the non-seasonally adjusted rate almost exactly. We match earnings yield data to inflation rate data based on monthly release of the latter in the middle of the next month. The chart shows that the range among inflation rates is usually about 1% and sometimes as high as 2%. The total inflation rates are generally more volatile than the core/trimmed rates, and more volatile than the stock earnings yield. When we test correlations between the non-seasonally adjusted inflation rate and the stock earnings yield by shifting one series timewise, the highest correlation is for coincident data. This result suggests that the inflation rate and stock earnings yield neither lead nor lag each other.
The next chart shows the average inflation rates and average gaps between the S&P 500 operating earnings yield and the various inflation rates. It shows that the volatilities of total inflation rates in comparison with core/trimmed rates tend to cancel over time. It also shows that PCE-based inflation rates tend to be lower than BLS rates, with the real earnings yield of stocks consequently higher. Results suggest that investors require a real earnings yield of 2-3%.
The next chart compares the average gaps between the S&P 500 operating earnings yield and the various inflation rates for four subperiods across the entire sample. It shows that the gaps vary between about 1.5% and 3% for different subperiods. It also shows that the current set of gaps (as of 12/14/06) is generally large in comparison with past subperiod and overall averages, but less substantially for those derived from the core/trimmed inflation rates.
The next chart compares the standard deviations of gaps between the S&P 500 operating earnings yield and the various inflation rates for these same four subperiods. It shows that the variability of the inflation rate-stock earnings yield relationship changes over time, and inconsistently with respect to different measures of the inflation rate.
The next two charts compare the behavior of the S&P 500 earnings yield to those of the non-seasonally adjusted BLS inflation rate and the PCEPI-based inflation rate. For both, we have ordered the inflation rate series from lowest to highest values over the entire sample period. The horizontal axes are therefore not time-sequential. The scales for the vertical axes are offset by roughly the average difference between the earnings yield and the inflation rate for the entire sample. This offset makes the graphs overlap for ease in seeing how much they do or do not vary together.
The charts show that the earnings yield generally tends to rise with the inflation rate, but the relationship is noisy. The degree to which the earnings yield graph bounces up and down across the inflation rate graph depicts the level of noise (as does the dispersion in a scatter plot). This format facilitates understanding whether the relationship and noisiness are stronger for some values of inflation than for others. The charts indicate that the stock earnings yield may not be sensitive to the inflation rate in the middle of the sample range. The relationship may be more reliable when the inflation rate approaches extremes of its distribution.
In summary, the PCE-based inflation rate may be a very slightly better indicator for the stock earnings yield than the total BLS inflation rates.
