As for inflation’s effect on P/E’s, I think interest rates are more relevent there. Whether investors choose stocks or bonds has a lot to do with expected return, so if interest rates are low, stocks will be more attractive than bonds even with high inflation.

It’s not a perfect model for sure, but I think the data does debunk the idea that we should think fair value on the S&P 500 today is 350-400 ($50 times 7-8).

I’d suggest that for two reasons your trough P/E analysis is not quite “apples to apples,” given that the data represent Dec. 31 closing price and LTM reported earnings.

First, generally speaking equities trade on future expectations rather than events in the past. To accurately represent S&P500 valuation at any year-end we need to use forward earnings estimates, not reported numbers. This data would not necessarily yield the same conclusion. I don’t have access to these historical projections, but let’s consider the implications.

For instance, take the ’73/’74 crash, which began Jan. 11, 1973. This Time article was published Jan. 8: http://www.time.com/time/magazine/article/0,9171,910532,00.html. Needless to say forward expectations were optimistic until days before the crash. If you were calculating the forward multiple at year-end 1972 it would be considerably lower than 19.1x due to grossly inflated expected earnings. Similarly, the forward multiple at year-end 1974 would in all likelihood be well above 7.3x, as mid-crash expectations for 1975 would probably be south of the actual post-crash report of $7.71. The upshot is that when using the appropriate valuation approach, your conclusion may not hold.

Second, you compare a relative multiple (“trough P/E”) to a nominal price (“trough earnings”), and conclude that they are not simultaneous. This is not an apt comparison because P/E is independent of inflation, while nominal earnings are not. Furthermore, from a valuation standpoint the market will pay less for high reported and projected earnings if it fears high inflation. In the two “trough P/E” years, 1974 and 1981, inflation was 11% and 10% respectively – near peak for each timeframe.

- Nathan