P/E Ratios and Inflation

One of the most basic rules for valuing the stock market is that the overall P/E Ratio should be equal to 20 minus the inflation rate. I was curious to see how good a measure of the market this is. Given how simple it is, it’s not too bad.
Here’s a look at where the rule would have valued the S&P 500 compared with its actual value.

The trouble spots are when there’s serious deflation. Still, I wouldn’t recommend using this as a market timing device. The average error is about 10%.
According to the latest numbers, the S&P 500 should be at 1,092.

Posted by Eddy Elfenbein on August 1st, 2008 at 10:15 am

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