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Affluent Christian Investor | December 8, 2023

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What The Stock Market Thinks About The Recovery

Investors have skin in the game. That means that when we are wrong and make the wrong allocations according to our error, we get punished. This does not logically imply that investors are always right. Bubbles seem to be a real thing. But it does mean that investors might have a more direct set of incentives when it comes to the economic outlook than, for example, pundits or people who are asked about their confidence levels in general opinion surveys.

Let’s look at one particular statistic that attempts to discern what the bets that investors are placing implies about their outlook for the economy. It’s called the “Equity Yield Premium,” and it’s simpler than it sounds. It is the difference between the valuation of treasury bonds and the valuation of the broad U.S. stock market. Treasuries are thought of as a ‘sure thing’. They are backed by the full faith and credit of the U.S. Government, which isn’t really a sure thing (even great nations have defaulted on their promises), but it’s still considered at least close to sure. Treasuries promise a certain annual amount of interest which does not vary, it’s locked in. What investors in treasuries give up in exchange for this security and predictability is a lower yield. They almost never get as much interest per dollar invested as they get in earnings for each dollar invested in the stock market.

Stocks, on the other hand, don’t make such promises. Management can pay a dividend, or not. It can do a buyback, or not. Over time, both dividends and buybacks come out of earnings — they have to, that’s the logic of the accounting system. So when one is choosing between stocks and bonds (especially the safer government bonds, not for instance ‘junk bonds’) one is choosing between taking a chance on future growth or locking in ‘the sure thing’.

We can see this equity yield premium below. Not surprisingly, it’s almost always above zero, meaning that investors almost never think of stocks as a more sure thing than bonds. They want extra yield for the thing that isn’t guaranteed. That’s the “premium” in “equity yield premium.” You can also see that during times of fear, this metric tends to spike.

If we translate this ‘spread’ (or difference) between stock valuations and treasury bond valuations into an expectation of economic growth, we get something that looks like the chart below. Further to the right represents a preference for bonds over stocks, i.e. fear. Further to the left represents a preference for stocks over bonds, i.e. optimism. If investors tend to be right, we would see the line sloping down, and we do. If investors were almost always right, we would see the dots very close to that line, and we do not. So investors have some insight about the future but they are far from prescient.

What does the investor class see when it peers through its somewhat smudged windshield? It sees recovery, but not a very strong one over the next year (this is as of the end of last quarter, the one we’re reviewing now). It’s pointing towards growth rates of about 1.5%. So, this statistic, like the PMI Survey we already looked at, and the spread between private bonds and treasuries which we will be looking at next, is one of many witnesses, each with its own useful, but imperfect, gauge of the economy.



Originally published on Townhall Finance.


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