Tuesday, April 1, 2014

Bond Yields And The Equity Risk Premium

  • High PE ratios do not signal an overvalued equity market.
  • Multiples are high because bond yields are low.
  • Bond yields are not artificially depressed by the Fed’s bond-buying.
  • Bond yields are likely to remain low, given the inflation outlook.
Duarte and Rosa at the NY Fed say that the equity risk premium is elevated at all horizons because the term structure of interest rates is depressed at all horizons. They say that the only thing that could reduce the ERP would be higher bond yields, and that earnings and dividend growth rates only play a minor role. That means that an equity investor cannot have an informed opinion about the stock market without also having an informed opinion about the bond market.
Stock market bears say that bond yields have been artificially depressed by the Fed's purchase of $3T of Treasury bonds, which represents a material proportion of the total float (about the same as the PBoC's portion). But I don't believe that QE is the reason why yields have fallen. If QE had been effective and had stimulated money growth, it would have raised bond yields. The idea that printing money depresses inflation expectations and bond yields is upside-down.
Bond yields are low because QE has failed. QE has had no impact on money growth or inflation or inflation expectations. Money growth since the crash has been anemic (~6%) and inflation and inflation expectations have trended steadily downward. We have gone from a disinflationary economy to a borderline deflationary economy. This is not good for workers (or earnings growth), but it justifies high PE ratios.

Inflation has not been this low since before the Vietnam war, and inflation expectations are very near their all-time low. Bond yields are at Eisenhower levels because inflation and inflation expectations are at Eisenhower levels. When you couple this with the FOMC's decision to reduce monetary stimulus in the face of declining inflation and inflation expectations, it's hard to build a case for higher bond yields. Since bond yields are unlikely to rise, then the outlook for stock prices remains bullish.

1 comment:

Alan Reynolds said...

Quite right. Unless bond yield rise a lot (why should they?) the p/e ratio is clearly quite low.
It amazes me that economists and journalists keep writing about price-earnings multiples as though they must revert to some long-term norm and are unrelated to interest rates.