WHY INFLATION AND TAX POLICY MATTER

EFFECTS OF INFLATION AND TAXES ON MARKET MULTIPLES

The price-to-earnings (P/E) is one of the most widely used ratios for valuing a company or the equity markets as a whole. Typically, when the P/E ratio is high relative to its history or compared to other securities, equities are said to be overvalued, and vice versa. According to Ned Davis Research’s calculation, the median P/E ratio for the S&P 500 was 30.36 at the end of January. This level is more than two standard deviations above its 56.9-year median. This means it occurs less than 1% of the time. It is approaching levels last seen prior to the dot-com bubble.

Figure 1: NDR’s calculation of the median S&P 500 price/earnings ratio.

Can these valuation levels be supported? A Valens Research study found that low-tax and low-inflation environments, like we are in now, or disinflationary environments support higher-than-average multiples. The table from Valens Research (Figure 2) shows that, since 1914, when there has been low inflation and lower taxes, the market has had an average P/E of 20.1x. But when inflation raises its head in a low-tax environment, the market has typically only sustained a 14.4 multiple. Valens observes, “The U.S. is currently in a low-inflation environment, coupled with low dividends and capital gains tax rates relative to historical rates that are likely to persist.” If inflation and taxes rise from current levels, the multiple could drop even lower and bring the markets down with it—something we’re watching.

Figure 2: The results from the Valens Research study on inflation and tax effects on multiples.

Given the amount of stimulus in the markets and the reduction in global manufacturing capacity, as well as the demand for a more specific set of goods and services, there have been rumblings that inflation may start to heat up. This seems to be holding true based on NDR’s Inflation Timing Model, which shows current inflation is not yet at alarming levels but has been in a strong uptrend since the beginning of last year.

Figure 3: NDR’s Inflation Timing Model continues to trend higher but is not yet at alarming levels.

As always, your Day Hagan Private Wealth investment team is constantly monitoring proposed tax policy and evaluating its effect on your portfolios. We’re very mindful that your real return is what you keep after paying taxes on gains. As you can see in the chart below, we are currently at historically low levels for long-term capital gains and qualified dividend tax rates, which have also been supportive of high market multiples. With a soaring budget deficit, the new administration could aim to increase these tax rates for additional revenue to offset stimulus spending. We will continue to monitor policy and share any significant changes.

Figure 4: Historical Long-Term Gains, Qualified Dividends, and Marginal Income Tax Rates.

As always, feel free to reach out with any questions regarding your accounts.  Keep in mind that you can always monitor your account’s risk number through the Day Hagan Client Portal.

Regan Teague, CFA®
Financial Advisor
Day Hagan Private Wealth

—Written 02.21.2021

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