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I've asserted several times in the past that the real yield on TIPS is a good proxy for the market's outlook for real economic growth, but I've never done a good job demonstrating that with charts. So I had an inspiration and came up with the following set of charts which I think does a reasonably good job. As I said last month, the extremely low (actually negative) level of real yields on TIPS tells us that the bond market is very pessimistic about the prospects for economic growth. Here are some ways to understand why that is so, and in the process to gain an understanding of just how cheap equities might be.

The chart above compares the 2-year annualized real growth of GDP to the real yield on 5-yr TIPS. What I'm trying to show here is that there is a correlation, albeit not very tight, between the level of real yields and the general strength of the economy. In the late 1990s and early 2000s, real yields on TIPS were fabulously high, as was optimism about growth. I remember thinking at the time that the markets were priced to the expectation that the economy would grow at 4-5% for a long time.

Since then, the economy suffered two recessions, and is still in the midst of the most disappointing "recovery" in modern times. Not surprisingly, the real yield on TIPS is as low as its ever been. Most TIPS yields are in fact negative, which means that investors are willing to lock in a negative real yield on default-free TIPS just for the privilege of knowing they won't lose any more than that, presumably because they expect that real yields could be even more negative on risky assets. The chart is suggesting that TIPS are priced to the expectation that real economic growth will be zero at best for the next two years, and that would undoubtedly lead to some very negative real returns on equities and corporate bonds.

I've showed this next chart many times over the past several years, always remarking that since the earnings yield on equities has been higher than the yield on BAA corporate bonds, this means the market is extremely pessimistic. Investors would rather accept a lower, fixed rate on corporate debt in order to have first dibs on earnings (which the market suspects will be in short supply in the future), rather than enjoy a higher earnings yield and the potential price appreciation that comes with being an equity owner.

This last chart ties real yields on 5-yr TIPS to the earnings yield on equities. The real yield on TIPS is inverted, in order to show that a lower real yield (and as the first chart suggests, a lower expectation for real economic growth) goes hand in hand with a higher earnings yield on equities. Real yields are very low and equity earnings yields are very high for the same reason: the market is very fearful that a recession and/or a period of prolonged economic stagnation awaits us. The market is unwilling to believe that the record-high level of corporate profits will last. The market is priced to the expectation that the economy will be very weak and profits will collapse. While that may prove to be the case (the market is sometimes, but not always, right), it is nevertheless a very pessimistic way of looking at things. I think it reflects the mood of investors that have been "once burned and now twice shy." I think emotions are running high and valuations may therefore be unreasonably low.

Looked at another way, if the economy ends up doing anything better than a recession, then valuations will most likely improve. You don't need to be a raging optimist to like the market, you just need to be less pessimistic than the market.

Source: What TIPS Tell Us About The Outlook For Growth