The big difference between today and the 1980s: Valuations

The figure below shows two main graphs. The graph at the top shows the Fed funds rate from 1978 to 1987, approximately the period in which Paul Volcker served as Chair of the Federal Reserve. Rate hikes preceded the 1980 recession. Rates were raised again around 1981, then reduced, and then raised again; leading to the 1981-1982 recession.

The graph at the bottom shows the U.S. 10 Year Treasury yield, the CPI inflation rate (left scale), and the value of the S&P 500 index (right scale). Note that the U.S. 10 Year Treasury yield generally followed the Fed funds rate in the period, and that both were high while CPI inflation was still within approximately two-thirds of its previous peak. Interestingly, the S&P 500 was mostly flat during this period of major turmoil.

Could one conclude that the Fed’s current hiking cycle to combat inflation may have a similar outcome – i.e., a period where the S&P 500 is mostly range-bound? While it is possible that the answer to this question is “yes”, there is a big difference between today and the 1980s, namely valuations. The figures below show the valuations in the 1980s and now.

As you can see, valuations in the 1980s during the two recessions were largely below 10, whether we look at the S&P 500 PE ratio or the corresponding inflation-adjusted Shiller PE10 ratio. Today they are slightly above 20 (PE ratio) and 27 (PE10 ratio). The video linked below discusses these and related issues, as well as some recent developments.