A number of commentators, some of them friends, have been declaring that current stock market valuations prove that the economy is in full recovery. They think that the market reflects high levels of optimism about the future and that this means that the economy is in a V-shaped recovery, or that we’re about to enter a phase of strong economic growth. Not so fast.
The optimism case is generally inconsistent with the weakening spate of recent economic statistics this week including ISM and jobs growth. Furthermore, it’s hard for anyone who writes or speaks from any principled free-market perspective to square optimism with the current policy environment which is unusually hostile to markets. So the optimist club turns as a last refuge to stocks.
Stocks by themselves might be showing some signs of optimism about growth (or at least monetary easing), but the equity market is not the whole market. Yes, when stock prices go up, that can often be a sign of optimism, but not when bond prices have gone up more. In other words, at the risk of oversimplifying: when investors are buying more stocks than bonds they expect growth. On the other hand when markets are buying more bonds than stocks (as they did in response to this week’s lousy March jobs report), they expect stagnation or even contraction.
In order to understand what the market is saying, you have to break off the bond market from the stock market in order to compare them and see what gifts the data (Latin for givens or gifts) offer.
What we find when we break up the various factors to examine them individually is that growth matters for stocks, but that its main effect is not in the total valuation of stocks, but in their valuation relative to bonds. And doesn’t that make sense? Bonds are generally fixed return investments: you can either take a chance on stocks and your return varies with the ups and downs of the earnings of the companies, or you can bet on the sure (well, not absolutely sure) thing by buying a bond.
From a growth perspective, stocks and bonds are valued properly in relation to one another when the stock yield is sufficiently higher than the bond yield to compensate you for the risk of future earnings shortfalls. This difference in valuations is called the equity risk premium, and the more pessimistic the growth prospects for the future, all other things being equal, the higher that premium should be.
Sometimes when growth prospects for the future appear to be wonderfully bright, that premium actually becomes negative: the relationship inverts as if to say that the future is so bright that we believe that stocks, even though they don’t guarantee a fixed minimum return, are lower risk than bonds. Once in a great while the future is so bright that a negative equity risk premium makes sense, but most of the time the phenomenon is a sign of a stock bubble…irrational exuberance.
If we look at the relationship between risk premiums and growth one year later (using data from roughly three dozen countries over the past decade) we find the following:
This data helps to shed light on the relationship between stock returns and growth, by honing in on the relationship, that is the spread, between stock and bond valuations on the one hand and growth on the other. EYP refers to Earnings Yield Premium or sometimes equity risk premium or just risk premium.
In order to calculate an earnings yield premium you must first calculate an earnings yield. You do this by simply dividing the past 12 months’ earnings of a particular stock index (or individual stock) by the current price of the stock. A security which costs $100 and which has earned ten dollars per share over the past year, has a 10% earnings yield. If you suddenly became wildly optimistic based on some piece of news you just saw on TV about this particular investment you might be willing to pay twice as much, maybe even $200 for it. If you did and the earnings have not changed, then the yield would be 5%: $200 divided by $10.
Or perhaps you became dreadfully pessimistic a moment later and you and the other buyers were only willing to pay $50 for the same $10 of earnings. Then your earnings yield would be 20%. So, in case you have not noticed the pattern: when the price goes down, the yield goes up and when the yield goes down, the price goes up. This makes perfect sense: when you are pessimistic you require a higher yield than the one you would require if you were optimistic. But how high is high, and how low is low? What should you compare these earnings yields to in order to get some idea whether they are excessively high or low? There are many other yields to compare them to, but for purposes of isolating factors having to do with growth, the most useful is to compare equity yields with bond yields, especially government bonds.
If the point is to find out how much growth pessimism or growth optimism there is in current market pricing, then comparing the earnings yield of a stock market (which tends to go up and down on conjunction with growth) to government bonds which pay the same amount every year, is the purest analytical tool I know of to do that. This calculation yields a number called an equity risk premium. It is the amount by which the generally riskier equity yield exceeds the less risky bond yield. The higher the number, the more risky investors think stocks are than bonds. And since the main macroeconomic factor which affects the comparative attractiveness of stocks and bonds is growth, equity risk premiums are largely a measure of how much risk investors think there is of poor economic growth in the future.
As you can see from the chart above, there is an historical relationship in theUnited States between rising equity yield premiums and falling growth. Currently the equity yield premium is almost 5%, which is much closer to the historic maximum than it is the historic average (which is a little less than 1%). This means that the current market valuations are anticipating a time of low growth.
Given the historic relationship between the risk premium and economic growth, the market is currently forecasting a growth rate over the next few years of about 1%. It’s not that this model is perfect; the data above show only a 53% negative correlation between risk premiums and GDP growth. So in my model this factor gets a modest weight, but it still fits well with a long list of other similar factors with much higher correlations which paint the same picture – America is in a period of economic stagnation, and will be for some time.
The point is not to look for the optimism case, or to look for the pessimism case: the point is to look for the truth. Investors and citizens deserve no less than that.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com