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Summary

  • High P/E ratios do not signal an overvalued equity market.
  • Multiples are high, because bond yields are low.
  • Bond yields are not depressed by the Fed's bond buying.
  • Bond yields are likely to remain low, given the inflation outlook.

Duarte and Rosa at the NY Fed say that the equity risk premium is elevated at all horizons, because the term structure of interest rates is depressed at all horizons. They say that the only thing that could reduce the ERP would be higher bond yields, and that earnings and dividend growth rates only play a minor role. That means that a macro-level investor needs to have an informed opinion about inflation and the outlook for bond yields.

Stock market bears say that bond yields have been artificially depressed by the Fed's purchase of $2.3T of Treasury bonds, which represents a material proportion of the total float (but much less than that of China's Treasury portfolio). But I don't believe that QE (or China) is the main reason why yields have fallen to such low levels. If QE had been effective and had stimulated money growth, it would have raised bond yields. The idea that printing money depresses inflation expectations and bond yields is upside down. The Treasury market, with respect to both flows and stock, is much bigger than QE.

Bond yields are low because QE has failed to raise inflation expectations. QE has had no impact on money growth, or inflation, or inflation expectations. Money growth since the crash has been anemic (~6%) and inflation (1.1%), and inflation expectations (2.0%) have trended steadily downward. The PPI has been flat for the past three years. We have gone from a disinflationary economy to a borderline deflationary economy. This is not good for workers (or earnings growth), but it justifies high P/E ratios.

Inflation has not been this low since before the Vietnam war, and inflation expectations are very near their all-time low. Bond yields are at Eisenhower levels, because inflation and inflation expectations are at Eisenhower levels. When you couple this with the FOMC's decision to reduce monetary stimulus in the face of declining inflation and inflation expectations, it's hard to build a case for higher bond yields. Since bond yields are unlikely to rise, then the outlook for stock prices remains bullish.

Source: Weak Inflation Supports Current Equity Prices

Additional disclosure: I am long stocks and bonds.