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A powerful argument is being made by my good friend and frequent Market Forecast panelist, Rich Bernstein, in his most recent report – “Valuation Now at Historical Extreme”. The chart above (click image to enlarge) is from Rich’s report and shows what I noted last Thursday, Stagflation Lite? – inflation coupled with a slow growing US economy warrants a much lower P/E ratio then the current “great times” level of 20x earnings.

As the chart plainly shows, the current level sits well outside the sloped trend line and ominously close to the prior market peak levels of March 2000 and August 1987.

Partially explaining this enthusiastic valuation level and a major factor in distorting valuation models is the optimism expressed in the bond market, both in longer-term Treasury yields (10 year, for example) and TIPS spreads, as well as a remarkably low VIX. All three are at odds with the potentiality of a highly uncertain period ahead, exemplified by a stagflationary environment, even a stagflation lite version. Troubling is the fact that corporate default rates are set to rise beginning next year, perhaps producing a flight to quality conundrum, which may explain in part the currently low yields the US Treasury markets are producing. Yet, unless one buys into a global recession scenario*, this low yield/low risk conundrum warrants valuation model adjustments to reflect the stagflation risk, if not the generally uncertain times ahead.

Investment Strategy Implications

While my investment strategy conclusions may differ from my good friend Rich’s, his primary point re inflation and P/E ratios is highly relevant and most timely. As investors face the last third of this woeful year, a look ahead into 2009 is fraught with danger. And despite the recent, and I would argue overdone, commodity price reprieve, one cannot exclude from that list a stagflationary environment that must find its way into valuation models.

Therefore, while the near-term countertrend rallies (and concurrent cyclical corrections in commodity related sectors) may encourage some to view any stagflationary environment as moot, I would prefer to participate while not losing sight of the looming valuation adjustment process.

*Conversely, one must buy into the rose-colored glass view of bottom-up analysts, as noted last Tuesday ("There They Go Again").