Update: It seems like people are 2% less irritated since I wrote this.
I have read that everybody hates the equity rally and that it must therefore run further. That may or may not be so, but it is not what this post is about.
My point is more literal and not an effort to be contrarian. Some people actually dislike the rally. It is not just that they don’t think it will run further.
As I see it, there are (at least) two reasons. First, a lot of people were really heavily invested in the 2008 end-of-world scenario, and have since been pretty angry that monetary policy makers have done their jobs. For them, the rally is “fake” and a nagging reminder they got something wrong.
A great indication that somebody hates the rally on this basis is if they use the words “distorted” or “unnatural.” Unnatural applied to monetary policy is particularly telling. There is no such thing as “natural” monetary policy. Money is a social convention and therefore inherently an artifice, artificial. But there are a lot underinvested tree-hugging monetary theorists these days.
Second, there is a more technical reason people — including me — dislike the equity rally, which is more about the rally itself and less about the people observing it. The rise of the equity price is part of a fundamental process driving down the total return.
This may seem like an extremely obvious point to make, bordering on a tautology. But it is not quite. Often we think of prospective returns being eroded by equities becoming expensive. Obviously, if equities are expensive, then their prospective return will be lower. That is kind of the definition of expensive.
But it is not clear to me — or others I think — that this is actually what is going on. Arguably equity prices are fair, relative to the “fundamentals.” Or at least they are not glaringly unfair. And yet prospective returns look low. You might say equities are fairly priced to deliver low returns. Who likes that?
Let me explain. By many accounts, the growth outlook has deteriorated, which reduces the prospective return directly. But the deterioration of the growth outlook has not had an effect on the “fair” price of equities because it has been offset, within the logic of a market DDM, by lower real bond yields.
If the change in the growth rate and the change in the real yield are the same, then within a DDM, arithmetically, they are a wash. So there is no deterioration of “value” but there is a seemingly permanent decline in the prospective return. You can’t confidently be short, because they are not necessarily rich. But you just know that returns from here blow.
That is actually new, a lagged reflection of the growth outlook deterioration. And it is irritating.
At the same time and operating in the same direction, low economic volatility seems to have come back. I hesitate to call this the return of the Great Moderation. As others have pointed out, there is not much great about reduced volatility around what seems like a very slow growth prospect. But if economic volatility is low, then the equity premium might tend to decline. That would force the P/E up, even relative to what is implied by the interaction of growth prospects and real bond yields.
The chart below shows some evidence that this might be going on. (If volatility determined the equity premium and if bond yields moved one for one with the growth prospect, then the two lines would sit atop one another.) The relationship is not perfect. And nor do I cut the 1950s and early 1960s out to obscure that point. Also please note, I chart the earnings yield. When it goes down, the P/E is going up.
But if underlying economic volatility (not just VIX) is low, then the risk premium may be reduced, which in turn reduces the likely total return for any growth outlook. And if the latter is weak too, well that is just irritating.
I’m in the camp hoping the stock market will crash to drive up the prospective return. After all, cheap to crap fundamentals might generate a decent return. I steal this somewhat obvious point from Philosophical Economics, which is worth reading on this point. But I got no right to expect them to get cheap. And that is irritating.
Now, this argument might sound pretty close to the bubbly argument that stock prices should go up because bond yields are low. If you misread it that way and are now all riled up at how dumb it is, then maybe you are in the first group of irritated people.