Alan Reynolds Associates

The Stock Market Likes Bonds

The graph _presents an intriguing
puzzle. Shaded bars show the ratio
of earnings to stock prices. [This
is the inverse of the price/earning
ratio - a low bar means stock prices
are high, relative to earnings.] The
The graph's main puzzle is that the
stock multiple often seems to improve
before bond yields fall - look at
1975, 1979-80 and 1989-90. There is
only one year on the graph that looks
out of place - 1987 - since stock
10-Year U.S. Treasury Bond Yield
and the Earnings/Price Ratio of Stocks
{S&P 500)
-- 10 yr bond + core inflation (PPI)
percent (bond yield & inflation)
+
15 -
D earnings/stock price
e/p ratio (stocks)
15
I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I
60 65 70 75 80 85 91
1991 is forecast
core inflation is PPI Dec-lo -Dec
(less food and energy after 1973)
dark line shows the yield on 10-year
Treasury bonds. Stock multiples are
obviously quite closely related to
bond yields.
At first glance, this may seem
obvious. As interest rates fall, the
present value of future earnings is
worth more, because it is discounted
at a lower interest rate.
prices were high relative to earnings
(for the year as a whole), yet bond
yields were high too. However, this
anomaly was "fixed" in October of
that year, as stock prices collapsed
and bond prices rose. Today, high
stock prices, relative to low
earnings, are simply not consistent
with a bond yield as high as 8%.
Something has to give. The critical
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question, of course, is whether that
means stock prices must fall, or that
bond prices will rise. With the sole
exception of late 1987 (a period
different in many ways from today),
this evidence suggests that bonds are
overdue for a significant rally.
To bring stock multiples into line
with bond yields, some combination of
the following has to happen: (l)
stock prices have to fall, (2)
earnings have to rise, and/or (3)
bond prices have to rise. As can be
seen in the graph, my forecast for
1991 puts most of the adjustment on
bond yields, which remain below 7.5%,
on average, for this entire year.
Earnings and stock prices both rise
over the course of the year. For
1991 as a whole, though, earnings
still look low relative to stock
prices. The market is buying
improved prospects for future
earnings, not just the current
dividend.
Investors may expect the stock
market to follow bond rallies, not
lead them. But the idea of stocks
moving first is not really strange,
just unfamiliar. First of all, it is
common to explain a rally in stocks
of utilities or banks, for example,
as a bet on a bond rally that has not
yet appeared. This is no different
than seeing stocks of oil companies
change in anticipation of a change in
oil prices that is likewise not yet
visible. Interest-sensitive stocks,
in particular, may thus be seen as a
measure of expectations about bonds.
Second, a big rally in stocks
reduces the dividend yield, making
the coupon on bonds begin to look
relatively attractive to marginal
investors. A marginal portfolio
shift into bonds is particularly
likely when long-term yields are well
above short-term, as they are now.
Rick Mishkin's extensive research on
yield curves reveals that "when the
spread is high the long rate will
fall.
1
Third, and most significant, there
is a common force at work that
affects both stock multiples and bond
yields - namely, expected inflation.
The graph shows producer price
inflation, less food and energy,
which I expect to be well below 3%
(down from 3.5% last year). Robert
Shiller of Yale finds that stock
prices are more sensitive to
inflation than bonds, which is
consistent with the view that bond
investors have something to learn
from stocks.
2
In contrast to the Keynesian view,
our expectation of lower inflation is
a both consequence and cause of
increased real activity. Lower
prices of homes, for example, help
sell houses. Higher growth of
production and productivity helps
keep costs and prices down. Lower
inflation also improves the quality
of profits, and reduces the effective
tax rate on real profits and capital
gains. That is one reason why stock
prices stay high relative to
earnings. And the inflow into . u.s.
markets associated with attractive
stocks and bonds keeps the dollar
strong, further contributing to a low
inflation environment.
An important implication of this
analysis is to avoid the herd
instinct to sell bonds on news of
stronger real activity. Another
recent National Bureau study
demonstrates that "news of higher-
than-expected real activity when the
economy is already strong results in
lower stock prices, whereas the same
surprise in a weak economy is
with higher stock
prices." Going back to the graph,
good news is thus likely to drive
stock prices up more promptly than it
does earnings. And when the
earnings/price ratio falls, that has
always been associated with lower,
not higher, long-term interest rates.
What is good new for stocks is now
good news for bonds too.
Alan Reynolds
March 21, 1991
====================================
1. Fredric s. Mishkin, "Yield Curve" NBER Working
Paper No. 3550, Dec. 1990
2. Robert J. Shiller & Andrea E. Beltratti, "Stock
Prices and Bond Yields ... " NBER Working Paper No.
3454, Oct. 1990.
3. Grant McQueen & V. Vance Roley, "Stock Prices,
News, and Business Conditions" NBER Working Paper
No. 3520, Nov. 1990.