Consider Real Rates, as defined by the trailing-12 month inflation subtracted from the 10-year yield:
Real rates out to 10 years are as low as they have been since the 1970s. To wit, here is the kernel density graph of real rates over that time:The only time in modern history that real rates have been lower was during the 70s, which had real inflation – touching 14.5% in 1980! But, as we see, inflation in the 70s was largely a function of bumping up against capacity constraints. U.S. TCU is now running at 77.8% – far closer to the troughs than the peaks of that decade. The S&P 500 closing value on Friday was 1,255:
It is remarkable to note that this closing value has been hit in six different years. Earlier on Twitter, I opined:
You know what’s awesome? The promises made in 1998 during the dot-com boom were delivered. Just 14 years later.
Now that we’ve got the earnings (of the record variety, and at the steepest discount in many decades) to back up the promises of a new technology-based economy, will equities be able to lift off from the clearly overwhelming pessimism?Take a look at the ERP (Earnings Risk Premium – earnings yield minus risk-free rate) graph from the Robeco Investment Management newsletter from 2009, “Skeptics May Be Confounded“: Only twice has the present ERP been eclipsed — at the height of the Great Depression, which was at the tail-end of a 30% decline in Real GDP, and in 1951. In neither case did it last very long (this is a highly mean-reverting series), and equities outperformed substantially in the years following. Take the scenario we outlined in The Fat Pitch: in 1975, earnings declined 18% while the S&P rose 32%. This is what happens when expectations are thrown so far out of equilibrium that you have an earnings yield of 7.6% with a negative real rate of that touched -2% out to 10 years. I can’t say I like risk-free instruments at these prices. At the very least, I’d recommend hedging your duration risk, particularly in the belly of the curve. The bears substantially underestimate the pessimism already baked into priced.