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Understanding the 'Great Earnings Yield Divergence': A Response to Felix Salmon
The Fed Model and its variants are simply wrong. There is no theoretical basis for believing that equities should yield the same as Treasuries. Equities are several times more volatile, for one thing, and so one would need to compare the earnings yields of equities to a levered portfolio of Treasuries to equalize the volatilities. Once one does that the "misvaluation" goes away. Moreover, the article is cheating by using 10yr Treasury yields rather than 30yr Treasury yields, which are almost 150bps higher. Even a 30yr Treasury might not represent a perpetuity yield at this point given the significant slope in the yield curve even at that timescale, with the forward rates significantly higher than YTMs all the way out.
But the real intellectual slip-up inherent in the Fed Model is that equities often behave as if they have a negative effective duration for long periods of time (i.e. decades), which makes comparing their yields to Treasuries not even wrong. Equities have had a negative effective duration since the late 1990s, when the Fed Model broke down. Expecting equities to have the same yield as Treasuries makes no more sense than expecting an interest-only MBS strip to have the same yield as Treasuries (the IO having a negative duration).
The negative duration of equities arises when the capital structure of firms includes lots of leverage. Effectively the balance sheets of many corporations are short corporate bonds with some leverage factor, and so declines in Treasury yields correspond to spread-widening in corporate bonds, creating the negative correlation that gives rise to the negative duration effect. Even if particular corporations have no leverage, if their customers do then their earnings will show the same pattern. As the whole economy is tied to the problem-filled banking system right now, it's hard for most equities to fight the negative duration tide, even if their balance sheets are pristine. Equities will return to a positive-duration world when the deleveraging process is over, and the Fed Model will start to work again the way it worked in the 1980s.
Aug 15 03:53 PM
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