Hi Toof, Re: Inflation, interest rates and P/E............
It was the FED's removing the marketplace from its decisions on interest rates that had me modify Ms. Garzarelli's original effort. Interest rates were being falsely depressed by the FED even as there was measurable inflation.
Historically short term interest rates usually sit slightly above the core inflation rate. So, if inflation is 2%, then usually the markets price short term debt at around 2+% yield. This is true most of the time. However, by removing market forces from the equation, the FED forced interest rates below inflation and has held it there for a very long time. In the '80s, both inflation and interest rates were very high - around double digits even for S/T paper. Still, the interest rate was slightly higher than calculated inflation. The two track very closely over time but until the recent FED era very rarely and only for very short periods has inflation been higher than s/t interest rates.
To keep the integrity of the Relative Valuation metric, substituting inflation as measured by the Consumer Price Index helped to keep it from being falsely below where it should have been without FED interference. This seems to work during times of inflation and deflation.
Generally, when interest rates are falling the stock market is bullish (and P/Es are usually expanding). As interest rates rise, then risk free returns compete more effectively with the stock markets and we will see P/E ratios contract (a bearish event). If these changes occur slowly the markets usually adjust with no major shocks.
The problem with you idea is since without FED manipulation S/T interest rates and inflation are very closely linked, subtracting inflation and then adding interest rates would nullify the effect that Ms. Garzarelli had noted. Since 2000, the average value of S/T Interest divided by CPI Inflation has been just 0.50. Before 2000 it has almost always been a ratio greater than 1.00. Even January through Dec of 2000 had an average ratio of 1.25. The lowest value occurred right around the market bottom in Dec, 2011 at 0.0015! From August of 2005 through around December of 2007 the ratio had been above 1.00 quite consistently.
Since the 2008-09 market panic, the Interest Rate/CPI Inflation ratio has been very low (0.081) by FED direct manipulation. It's not just the US FED, either but essentially every central bank in the world. Current value here in the U.S. is 0.63 and the average for 2017 so far is 0.56.
How long will it take the FED to "normalize" ST interest rates? It's anybody's guess. I think it's good enough to understand that ST interest is not currently market driven (supply and demand). Further, since interest rates really can't go any lower, then we can assume that normalization will only drive them higher - most likely slightly above measured inflation rates.
If we assume interest rates will normalize at 1.1x CPI inflation, then we should see S/T rates at near 2% (core inflation is currently about 1.76%/year). If we were to add 2 to the current Value Line P/E of 20.1, it puts Relative Valuation at 22 which would be Bearish.
