Monday, June 9, 2014

Real yields and stocks

This is a follow-up to my post last week, "The importance of real yields," in which I compared real yields on TIPS to nominal yields on Treasuries, real GDP growth rates, and gold. I noted that real yields tell us several interesting things about the market's outlook: the market does not expect any meaningful change in the rate of inflation; the demand for safe assets is beginning to decline; and real GDP growth rates are expected to be low for the foreseeable future.

The chart above compares the earnings yield on equities (i.e., the inverse of the PE ratio) with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for price). It shows that when equity valuations are high (i.e., when the earnings yield on equities is low), the demand for safe assets is weak, and vice versa, and that makes perfect sense. In the late 1990s, equity markets were booming, the economy was growing at a 4-5% rate, and real yields were usually high. During those go-go years, in other words, the demand for stocks was strong and the demand for TIPS was weak. By the early 2010s, things had reversed: the earnings yield on stocks had soared (corporate profits were very strong but the market was very doubtful that those earnings would hold up), and the demand for TIPS had soared because everyone feared that the economy would remain weak or suffer another recession.

Over the past year, however, we have seen a divergence between these variables. Earnings yields have declined (i.e., multiples are rising), as the market becomes more confident in the outlook for earnings, but real yields have been relatively flat and are still quite low. In other words, the demand for equities is strengthening, but the demand for TIPS is not declining.

I think this is a good illustration of the tensions that are building between the stock and bond markets. Interest rates should be higher, given the rising level of confidence in the stock market. This is a theme that I explored in another post last week, in which I argued that even if real GDP growth is only 2-3%, the Fed should react sooner rather than later to the signs of rising confidence and start raising short-term interest rates.

It seems to me that the stock market is out in front of the Fed and the bond market these days. It doesn't make sense that equity valuations are rising and net worth is at new all-time highs, but short-term rates are zero and 5-yr TIPS real yields are negative.. The Fed needs to gain the same confidence as the stock market, and begin raising short-term interest rates. This would likely help give the bond market the confidence to shun Treasuries, thus restoring the balance between earnings yields and real yields.


Anonymous said...

Great posts on real yields and how to interpret them relative to stocks and the strength of the economy. Unique commentary based on your education and experience.. I've been learning a ton from you over the last few years.

Chris said...

I agree. It seems like a graduate-level econ class.

William said...

Today's US stock market rise produced 308 new highs on the NYSE and only 4 new lows. That is strong confident behavior in a strong bull market.

Before the market top, the broad indices will continue to rise but the new highs will be fewer and the new lows will rise. So far so good.

But after an 18 month rise in the S&P 500 with no more than a 6% correction, at these levels we must be alert to sins of the stock market "rolling over".

Jim Paulson expects a volatile year with the S&P 500 possibly rising to 2000 because of fast GDP growth; but then a scary 15 to 20 % correction because of inflation / rising interest rate concerns.

Having been as much as 126% long equities since 2009, I have repaid my margin debt by selling issues and am now only 97.5% invested in equities. If there is a melt UP, I might prefer to be only 80% long equities. Like Scott Grannis, Brian Wesbury, and Jim Paulson, I am not expecting a Bear Market.

I have been very long, for a very long time which I don't like to be but the pessimism was so great, I simply had to invest against such a majority.

Anonymous said...

I believe Scott's posts illustrating the disconnect between interest rates and the stock market are very prescient.

It seems in the short to medium term something has to reconcile.

Will we finally get the acceleration in real GDP that the stock market seems to be expecting?

And interest rates... Will they normalize with a stronger economy?

It's rumored that at an investment bank paid dinner Bernanke mentioned he doesn't expect the Fed funds rate to be set at its long term average of ~4.5% during his lifetime. (That could actually be a rumor).

So the textbook stronger GDP growth supporting a healthy rising interest rate environment seeeems very plausible. But because it seems so plausible there must be something unexpected to come with that story.

Will the expansion truly last until the Fed inverts the yield curve again? We are still at the zero lower bound.

I'm on pins and needles.

Following CBP.

Benjamin Cole said...

Great post, and interest rates are a puzzle...

You have a lot of experts such as Ben Bernanke and Bill Gross (PIMCO), say interest rates will be dead a long time. Japan-lite, in other words.

This may reflect global gluts of capital.

People forget---in free markets you are entitled to a return on your savings, and you are also entitled to a loss on your savings.

The idea of an assured real return is a government fiction, and started with FDIC deposit insurance, and then expanded to TIPS bonds.

If there are global gluts of capital, then savers in general should take losses. The market is trying to tell you something, and that is that it does not want your savings.

Some nations, such as China, somewhat compel savings, and others, such as Japan, seems to have huge savings pools perhaps due to cultural reasons.

Globally, incomes are rising, allowing pools of capital to form.

We are also seeing the formation of gigantic sovereign wealth funds--we are talking trillions of dollars. The SWFs are not market-result savings. It is nationalism.

And, as Scott Grannis has pointed out, there is a couple trillion laying around in US savings accounts.

In short, capital is everywhere. Sheesh, Ballmer can blow $2 billion on the Clippers because he wants to. What does that tell you?

So long-term rates are dead on safe passive investments, like US Treasuries.

John Cochrane says the Fed play going forward is to make permanent its huge balance sheet, and then use IOR to counter inflation.

My own guess is that the Fed is so inflation-phobic that it is asphyxiating the economy, and the slow growth is limiting demand for capital.

Meanwhile, non-market government deposit insurance is warping free markets, and people are still saving, despite what should be negative interest rates.

Plus there are huge pools of capital globally, due to non-markets in China and the SWFs. And today we have global capital markets.

It has been a long, long time since anyone heard the words "crowding out."

Guess why.

What does a world with too much capital look like?

A world with low interest rates.

The good news is that today any technology that appears promising can get financing. If you have a good business plan, the doors are open.

Benjamin Cole said...

(Reuters) - Bill Gross, manager of the world's largest bond fund at Pimco, said Thursday the firm believes the 'new neutral' inflation-adjusted federal funds rate will be close to 0 percent as opposed to 2-3 percent in prior decades.

"If 'The New Neutral' rates stay low, it supports current prices of financial assets," Gross said in his latest investment letter. "They would appear to be less bubbly."

steve said...

I cannot think of any mental exercise that is more wasteful than thinking about how stocks might perform at any point in the future. virtually the entire compendium of evidence shows beyond that shadow of a doubt that this is an exercise in futility and frustration. but that doesn't stop people from trying! the crime is that there are average investors who actually listen to "pundits" wax and wane on the merit on stock ownership when they should just buy an index fund and save themselves over 100 bps/year.

Anonymous said...

I believe the theme here is a reasoning of our complex domestic and global economic system.

A reasoning (not prediction) of the signals available to us in the form of economic data.

Stock prices are used as one signal in relation to dozens of others in effort to understand the state of the economy.

Pursuing a sense of understanding of complex systems can be very rewarding to some people.

Shana- Shape Your Bootie boot shapers said...
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ShanaED said...

Hi Scott et al, I'm very new at this game (new as in just learned the difference between a bull and a bear market) and I'm wondering if you, or any of your readers, could recommend a good book for a beginner. The jargon itself is overwhelming at this time! Real basic fundamentals. Thx in advance!

Anonymous said...


I would frequent this forum for investment advice and book recommendations.

William said...

John Bogle, the founder of Vanguard Mutual Funds, has written several books over the years. Below is a good one to begin with. He wrote it with David F. Swensen, Yale's Chief Investment Officer, who has a very good, long term investment record.

John Bogle: Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition (2009)

William said...
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