Fed’s Goal is to Cool Down the E in the P/E Ratio

Apollo Chief Economist

The P/E ratio for the S&P500 is today about 30% above its historical average, see the first chart. And the Shiller Cyclically-Adjusted P/E ratio, which adjusts earnings for inflation, is about 50% above its historical average, see the second chart.

The problem for the stock market is inflation. As long as inflation is significantly above the Fed’s 2% target, the FOMC will remain hawkish and try to tighten financial conditions to slow down growth, which is negative for the equity market.

The consensus currently expects CPI and PCE inflation at the end of this year to be between 4% and 6%, which suggests that we will have to get into 2023 before we know that we are not in a new regime with permanently higher inflation.

The key question for all markets is the following: How will the Fed respond later this year when the unemployment rate begins to move higher if inflation is still around 5%, as the consensus expects? And if the Fed turns dovish later this year in response to rising unemployment, how will long rates and breakevens then respond? It will ultimately be a test whether the Fed will put more weight on rising unemployment or on too high inflation.

Chart showing the S&P500's P/E ratio is still 30% above its historical average
Source: Robert Shiller, Apollo Chief Economist. Note: Price to earnings ratio, based on trailing twelve months “as reported” earnings.
Chart showing the S&P500's cyclically adjusted P/E is still well above its long-term average.
Robert Shiller, Apollo Chief Economist. Note: Price to earnings ratio, based on trailing twelve months “as reported” earnings.

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