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.