Bonds beat stocks (4)

This chart revisits the subject of earlier posts. It compares the yield on junk bonds (inverted) to the S&P 500 Index. The two markets are highly correlated, as you see in the chart, and this is typical over longer periods as well. The interesting thing to note is that the market for high-yield (junk) bonds has improved significantly so far this year, while stocks have languished.

Newer readers probably missed seeing my post in mid-November titled "Is this the end of the world or the opportunity of a lifetime?" In it I described key features of the Great Depression (e.g., real GDP declined by 26.5% over four years, and the peak of rate of defaults on all corporate bonds reached 14% in 1936), and compared it to the assumptions implicit in the pricing of equities and corporate bonds at the time (e.g., 24% of all corporate bonds would default within 5 years, and GDP would decline by almost twice as much as it did in the 30s). In other posts I have commented on the strong deflation expectations that were built into TIPS, and how these were questionable given that monetary policy in this crisis has been massively stimulative, while monetary policy was massively contractionary in the 1930s.

In short, in November our markets were priced for a future that would be much worse than the Great Depression. If the market was to be believed, then we were about to witness the end of the world as we know it. I thought that was pretty unreasonable, and so I thought that stocks and bonds were so incredibly cheap that it was hard to believe.

Now, six months later, the corporate bond market has repriced itself sharply higher (as yields and spreads have fallen), which means that the market has dramatically reassessed the likelihood of corporate defaults. This improvement was foreshadowed by a significant narrowing of swap spreads last year, another subject I have commented on many times, and it is supported by all the "green shoots" that we have seen in recent months which suggest that the economy is stabilizing. TIPS have also improved, as deflation expectations have receded. Equities, however, haven't improved at all on balance. What does this tell us?

A: The equity market is simply slow to catch on to the improving fundamentals.

B: Since the economy no longer looks to be in freefall, default rates are likely to be much lower than the market earlier feared, but the outlook for profits remains dismal, due to fears of higher tax burdens, increased government regulation, cap and trade, nationalization, etc.

C: Deflation risk has dropped significantly; this makes bond defaults much less likely, but does little to improve the outlook for profits.

D: All of the above.

I would choose D, for want of a better explanation. Regardless, we are still left with a puzzle. With so many things having improved, including corporate bond prices and TIPS prices, why aren't equities doing much better? Even if equities rallied another 30%, they would still reflect an economic outlook that could be described as no better than grim.

Full disclosure: I am long IVV, TIP, WIW, EMD, PAI and HYG at the time of this writing.