Wednesday, June 6, 2012

What TIPS tell us about the outlook for growth

I've asserted several times in the past that the real yield on TIPS is a good proxy for the market's outlook for real economic growth, but I've never done a good job demonstrating that with charts. So I had an inspiration and came up with the following set of charts which I think does a reasonably good job. As I said last month, the extremely low (actually negative) level of real yields on TIPS tells us that the bond market is very pessimistic about the prospects for economic growth. Here are some ways to understand why that is so, and in the process to gain an understanding of just how cheap equities might be.


The chart above compares the 2-year annualized real growth of GDP to the real yield on 5-yr TIPS. What I'm trying to show here is that there is a correlation, albeit not very tight, between the level of real yields and the general strength of the economy. In the late 1990s and early 2000s, real yields on TIPS were fabulously high, as was optimism about growth. I remember thinking at the time that the markets were priced to the expectation that the economy would grow at 4-5% for a long time. Since then, the economy suffered two recessions, and is still in the midst of the most disappointing "recovery" in modern times. Not surprisingly, the real yield on TIPS is as low as its ever been. Most TIPS yields are in fact negative, which means that investors are willing to lock in a negative real yield on default-free TIPS just for the privilege of knowing they won't lose any more than that, presumably because they expect that real yields could be even more negative on risky assets. The chart is suggesting that TIPS are priced to the expectation that real economic growth will be zero at best for the next two years, and that would undoubtedly lead to some very negative real returns on equities and corporate bonds.


I've showed this next chart many times over the past several years, always remarking that since the earnings yield on equities has been higher than the yield on BAA corporate bonds, this means the market is extremely pessimistic. Investors would rather accept a lower, fixed rate on corporate debt in order to have first dibs on earnings (which the market suspects will be in short supply in the future), rather than enjoy a higher earnings yield and the potential price appreciation that comes with being an equity owner.


This last chart ties real yields on 5-yr TIPS to the earnings yield on equities. The real yield on TIPS is inverted, in order to show that a lower real yield (and as the first chart suggests, a lower expectation for real economic growth) goes hand in hand with a higher earnings yield on equities. Real yields are very low and equity earnings yields are very high for the same reason: the market is very fearful that a recession and/or a period of prolonged economic stagnation awaits us. The market is unwilling to believe that the record-high level of corporate profits will last. The market is priced to the expectation that the economy will be very weak and profits will collapse. While that may prove to be the case (the market is sometimes, but not always, right), it is nevertheless a very pessimistic way of looking at things. I think it reflects the mood of investors that have been "once burned and now twice shy." I think emotions are running high and valuations may therefore be unreasonably low.

Looked at another way, if the economy ends up doing anything better than a recession, then valuations will most likely improve. You don't need to be a raging optimist to like the market, you just need to be less pessimistic than the market.

8 comments:

Bill said...

Scott,

What I don't understand about this analysis is that the bond market has been predicting recession/depression since 2008. We got a deep recession but we've had about 3 years of at least some growth since the bottom of the recession. Is the bond market saying we've been in a depression since 2008 or are the low yields simply the result of the Fed's QE program plus the flight to safety from other countries?

John said...

Bill,

I am interested in Scott's take on why such pessimism reigns as well. i suspect many factors are involved. One is that its not 'once' burned. Many investors have been repeatedly burned by volatility that is simply unendurable to virtually everyone. Thus if they participate at all it is as traders. Also, so many see the game as rigged...computer high frequency trading (regardless of its reputed benefits), dark pools, hyperventilating financial market reporters, etc. The little guy is gone and won't be back anytime soon. Another is that fear is a more powerful emotion than greed. It takes time for fear to disapate and three nasty bear markets in ten years has ended many baby boomers equity investing for good except maybe for small percentages of their assets. Markets are controlled by hedge funds, and other professional traders using derivitives such as futures contracts, index options and even options on futures. (note the increasing correlation among market sectors)

There are many bright posters on this blog that have other insights that are likely valid. Perhaps a few will comment. But I agree with Scott that barring a global economic recession of long duration(some are predicting it) equities are cheap and offer good and rising income streams if the volatility can be tolerated.

Scott Grannis said...

The bond market is not telling us why expectations are so pessimistic, simply that they are. I interpret those expectations to be akin to expecting a global recession lasting years. If you don't believe that's likely, then the market is giving you better than even odds of making money by investing.

Public Library said...

You shouldn't compare the yield on equities to corproate bonds without adjusting for risk. Otherwise the chart is apples to oranges.

William said...

Old farts like me have seen this before - this prolonged aversion to equities.

The very late 1960s and early 1970s were extremely similar to the late 1990s and early 2000s. There was in fact quite a technology bubble and also the "nifty 50" bubble during that time. The later theory was that one could buy the largest 50 US corporations, put them away and would NEVER have to sell them until you needed the money. They of course rose to outrageous P/E ratios.

Then came the prolonged bear market of 1973 - 1974 followed by the oil market shocks and the rise in US inflation up to 11% annualized in 1980. The US Prime Rate rose to 20%.

The average investor didn't participate in the early years of the great bull market of the 1980s and 1990s and only jumped in with both feet in 1998 or 1999 - just in time for the bear market which began in March/April of 2000.

I believe that investors who purchased equities and stock mutual funds in the bull years of 1969, 1970, and 1971 continued to be net sellers of those assets until at least 1985.

Squire said...

It just may be that earnings will slow down and stocks are fairly priced.

Yesterday we talked about new QE possibly being ineffective or detrimental. From Zero Hedge late today, Morgan Stanley said QE was more correlative (to improved macro data) than causative. That QE works well as a preventative (of collapse) but not a cure to create growth.

Dr William J McKibbin said...

Dividend earning stocks are a bargain right now -- rent-earning real estate is as well -- it's that simple -- long-term investors with a 25-30 year horizon are buying the bargains of a lifetime right now...

William said...

Dr William J McKibbin said...
"Dividend earning stocks are a bargain right now -- rent-earning real estate is as well -- it's that simple -- long-term investors with a 25-30 year horizon are buying the bargains of a lifetime right now..."

I believe this to be the case. I just hope that I continue to have the stamina to tolerate the volatility. Seriously!