When real rates are elevated, fixed income gets a lot more attractive, and equities lose their luster. What’s punishing is a wide premium over and above the CPI that investors can get from purchasing bonds instead of stocks. Companies raise prices to cover their costs, so their revenues should increase in tandem with relatively modest inflation.

What matters in calculating how many dollars investors will pay for each sawbuck in earnings isn’t the “nominal” but the “real” yield. Here’s where the stunning rise in the 10-year is so decisive. Now, we need a normalized PE multiple to attain a reasonable valuation for the S&P. Hence, the Shiller formula implies that by reverting to the mean, EPS will trend not upwards from here, but southwards toward $160.

Add the premium, and the best measure of where earnings should settle is around $160 (Shiller’s $149 plus 10%). That’s because the CAPE only increases past profits for inflation, not for “real” gains usually tied to economic growth. AQR, one of America’s great quant firms, is said to mark up the CAPE by around 10% to get what it considers the best real-time estimate. It calculates a 10-year average of inflation-adjusted EPS, then uses those recast earnings to judge if stocks are over- or undervalued. Nobel Prize laureate and Yale professor Robert Shiller offers a metric called the cyclically adjusted price-earnings ratio, or CAPE, that removes those steep peaks and deep valleys, and smoothes the numbers to get a figure for bedrock, repeatable profits. Right now, S&P earnings per share are experiencing the former phenomenon. They regularly spike to unattainable heights or drop to levels from which they’re bound to rebound. Corporate earnings are highly cyclical and erratic. The rub: The current market math suggests that a PE even in the low-20x range is too high, and earnings are more likely to drop substantially from here than wax by 15% in just four quarters to $230. So why worry? The bull case numbers don’t add up If that happens, America’s big caps could reach over 4,800 at what the bulls would consider a modest price-to-earnings ratio, or P/E, of 21x by next summer.

On average, the market strategists forecast that trailing 12-month GAAP profits will rise from $200 per share in the first quarter to $230 per share in the second quarter of next year. In fact, if you believe the analysts’ earnings predictions for the next few quarters, an outcome where the index retraces its August highs, then keeps chugging forward next year, appears plausible.

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