Today's email brought a question I've received and privately replied to several times in the past regarding the P/E10 ratio in my monthly market valuation update. This time I'd like to share the question and illustrate the answer with a chart. First the question:

I don't understand why the P/E10 needs to be adjusted for inflation. Doesn't inflation in the price (numerator) cancel out inflation in the earnings (denominator)?

Actually it doesn't. That's because the nominal earnings during trailing 10-year periods of high inflation would give an elevated P/E10 value. The reverse is the case during deflationary trailing periods.

In this version of my monthly valuation chart I've added a nominal P/E10 and highlighted the nominal versus real P/E10 ratios in the callouts. Study this dual P/E10 chart in relation to this snapshot of historic inflation/deflation. Note, for example, that deflation makes the nominal P/E10 ratio at the 1932 bottom look even lower. In contrast, the inflation of the 1970s and early 1980s makes the nominal P/E10 ratio seem much higher at the 1982 bottom. To quantify this last example: The nominal P/E10 in 1982 is a stunning 52% higher than the real P/E10, thus obscuring the incredible value of the 1982 US market.

Hope this helps clarify!