7/29/2019 Alan Reynolds Links E-p Ratio to Bond Yield, March 21,
1991
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Alan Reynolds AssociatesThe Stock Market Likes Bonds
Th e graph _presents an in t r iguingpuzz le . Shaded bars show
the r a t i oof earnings to s tock pr ices . [Thisi s the inverse
of the pr ice/earningr a t io - a low bar means s tock pricesare
high , r e l a t i ve to earnings.] The
The graph 's main puzzle i s t ha t thes tock mult ip le of ten
seems to improvebefore bond y ie lds f a l l - look a t1975,
1979-80 and 1989-90. There i sonly one year on th e graph t h a t
looksout of place - 1987 - s ince stock
10-Year U.S. Treasury Bond Yieldand the Earnings/Price Ratio of
Stocks
{S&P 500 )
- - 10 yr bond + core inflation (PPI)percent (bond yie ld &
inflation)+
15 -
D earnings/s tock pricee /p ratio (s tocks)
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
I60 65 70 75 80 85 91
1991 is forecas tcore inflation is PPI Dec-lo -D ec(less food
and energy after 1973 )
dark l ine shows the y ie ld on 10-yearTreasury bonds. Stock
mult ip les areobviously qui te c lose ly re la ted tobond yie lds
.At f i r s t glance, th i s may seemobvious. As i n t e r e s t r
a tes f a l l , thepresen t value of fu ture earnings i sworth
more, because it i s discounteda t a lower i n t e r e s t r a t e
.
prices were high r e l a t i ve to earnings( for the year as a
whole), y e t bondyie lds were high too . However, th i sanomaly
was "f ixed" in October oft ha t year , as s tock pr ices col
lapsedand bond pr ices rose . Today, highs tock pr ices , r e l a t
i ve to lo wearnings , are simply not consis tentwith a bond y ie
ld as high as 8%.Something has to give . Th e c r i t i c a l
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we believe to be reliable but we do not guarantee its accuracy.
7/29/2019 Alan Reynolds Links E-p Ratio to Bond Yield, March 21,
1991
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quest ion, o f course, i s whether t ha tmeans s tock pr ices
must f a l l , or t ha tbond pr ices wi l l r i se . With the
soleexception of l a t e 1987 (a periodd i f f e r en t in many
ways from today) ,t h i s evidence suggests tha t bonds areoverdue
fo r a s igni f icant r a l ly .To bring s tock mult iples into l
inewith bond yie lds , some combination ofthe following has to
happen: ( l)stock pr ices have to f a l l , (2 )earnings have to r
i se , and/or (3 )bond pr ices have to r i s e . As can beseen in
the graph, my forecas t for1991 puts most of the adjustment onbond
yie lds , which remain below 7.5%,on average, for t h i s en t i r
e year .Earnings and s tock pr ices both r iseover the course of
the year . For1991 as a whole, though, earnings
still look low re la t ive to stockpr ices . The market i s
buyingimproved prospects for futureearnings , not ju s t the
currentdividend.Inves tors may expect the stockmarket to fol low
bond r a l l i e s , notlead them. But the idea of stocksmoving f i
r s t i s not rea l ly s t range,ju s t unfamil ia r . Fi r s t of
a l l , it i scommon to expla in a r a l ly in stocksof u t i l i t
i e s or banks, for example,as a bet on a bond r a l ly tha t has
notyet appeared. This i s no di f ferentthan seeing s tocks of o i
l companieschange in an t i c ipa t ion of a change ino i l pr ices
tha t i s l ikewise not yet
vis ib le . In te res t - sens i t ive s tocks,in par t icu la r
, may thus be seen as ameasure of expectat ions about bonds.Second,
a b ig ra l ly in stocksreduces the dividend yie ld , makingthe
coupon on bonds begin to lookre la t ive ly a t t rac t ive to
marginalinves tors . A marginal por t fo l ios h i f t in to bonds
i s par t icu la r lyl ike ly when long-term yie lds are wellabove
shor t - te rm, as they are now.Rick Mishkin 's extensive research
onyie ld curves reveals tha t "when thespread i s high th e long ra
te wil l
f a l l . 1Third, and most s igni f icant , therei s a common
force a t work tha ta f f ec t s both s tock mult iples and bondyie
lds - namely, expected in f la t ion .The graph shows producer pr
icein f la t ion , l es s food and energy,which I expect to be well
below 3%(down from 3.5% l a s t year) . Robert
Shi l le r of Yale f inds tha t s tockpr ices are more sens i t
ive toinf la t ion than bonds, which i sconsis tent with the view
tha t bondinves tors have something to learnfrom s tocks . 2In
contras t to the Keynesian view,
our expecta t ion of lower in f la t ion i sa both consequence
and cause ofincreased r ea l ac t iv i ty . Lowerpr ices of homes,
fo r example, helps e l l houses. Higher growth ofproduction an d
product ivi ty helpskeep costs and pr ices down. Lowerin f la t ion
also improves the qual i tyof prof i ts , and reduces the ef fec t
ivetax ra te on rea l pr o f i t s an d cap i t a lgains . That i s
one reason why s tockpr ices s tay high r e la t ive toearnings.
And the inflow into . u.s .markets associa ted with a t t r ac t
ivestocks and bonds keeps the dol la rs t rong, fur ther contr ibut
ing to a lowin f la t ion environment.An important impl ica t ion
of t h i sanalys is i s to avoid the herdi n s t i nc t to s e l l
bonds on news ofst ronger r ea l ac t iv i ty . Anotherrecent
National Bureau studydemonstrates t ha t "news of
higherthan-expected rea l ac t iv i ty when theeconomy i s al ready
s t rong r e su l t s inlower s tock pr ices , whereas the
samesurpr ise in a weak economy i s
a s s o c i a t ~ d with higher s tockpr ices . " Going back to
the graph,good news i s thus l ike ly to drivestock pr ices up more
promptly than itdoes earnings. And when theearnings/pr ice r a t io
f a l l s , tha t hasalways been associa ted with lower,not higher
, long-term in te r e s t r a t e s .
What i s good new for s tocks i s nowgood news fo r bonds
too.Alan ReynoldsMarch 21, 1991
====================================1. Fredric s. Mishkin,
"Yield Curve" NBER WorkingPaper No. 3550, Dec. 19902. Robert J .
Shiller & Andrea E. Beltratti, "StockPrices and Bond Yields . .
. " NBER Working Paper No.3454, Oct. 1990.
3. Grant McQueen & V. Vance Roley, "Stock Prices,News, and
Business Conditions" NBER Working PaperNo. 3520, Nov. 1990.
