Correlation theory doesn't stack up
SERIOUS MONEY:LEGIONS OF investors have been schooled to believe that Treasury bond prices and the major stock market indices should move in the same direction. In other words, changes in the valuations that investors attach to both high-quality sovereign debt and equity markets are presumed to be positively correlated.
In this context, it is not surprising that each time bond yields drop to fresh generational lows, the uber-bulls declare that stocks have rarely looked so cheap relative to their fixed-income cousins.
The optimistic hypothesis is nothing more than a stale remnant of the dangerously flawed thinking that dominated investment strategy during the heady days of the late-1990s. Not surprisingly, the use of models without theoretical foundation ultimately proved disastrous for bottom-line investment performance.
The supposed positive relationship between bond and equity yields has not been observed in financial market fluctuations for more than a decade, as ever higher bond valuations have been greeted with lower cycle-adjusted price/earnings multiples. Nevertheless, the argument continues to feature heavily in investment commentary, and few practitioners even bother to search for reasons as to why the presumed relationship may not be valid in the current climate.
It is important to appreciate that the secular trend in debt and equity valuations is regime-dependent, and what worked well in one period may not hold true in another.
The primary determinant of bond and stock market valuations is the volatility of inflation – the uncertainty regarding future inflation. High levels of inflation uncertainty make it increasingly difficult to isolate the signal from the noise emanating from fluctuations in the general price level.
As a result, elevated inflation volatility is accompanied by relatively poor growth outcomes.
The historical record demonstrates that inflation volatility has been at its lowest when the inflation rate has been sustained in a range of 2 to 4 per cent. This can be defined as the “sweet spot” of effective price stability and has historically been characterised by fewer and milder recessions, and higher long-term economic growth.
Once the inflation rate strays outside the 2 to 4 per cent range, on a sustained basis during inflationary and deflationary regimes respectively, inflation volatility trends higher and negatively impacts long-run growth.
It is important to note that high inflation volatility is universally bad for equity valuations. Investors demand a higher risk premium over and above the real risk-free rate to compensate for the greater variability in cash flows, and mark down equity valuations even further to reflect lower expected future real growth.
In other words, the high inflation volatility observed in both deflationary and inflationary regimes precipitates a secular bear market in stocks, as valuations are struck by the double-whammy of a higher real discount rate and a lower expected future real growth rate.
This is exactly the phenomenon that was observed in the deflationary 1930s, the inflationary 1970s, and once again in recent times as inflation volatility jumped to the highest level in 30 years.
Although high inflation volatility is negative for equity valuations in both deflationary and inflationary regimes, the same is not true for treasury bond yields. An inflationary regime is accompanied by a secular bear market in bonds, as investors incorporate not only higher expected future inflation into yields, but also a higher inflation risk premium to compensate for the greater inflation uncertainty.
However, a deflationary regime is accompanied by a secular bull market in bonds, as investors become increasingly willing to pay a premium for financial assets that will provide insurance during poor economic states.
This effect has been particularly pronounced in recent times, as investors learned to their cost that few asset classes provided any protection whatsoever during the global financial crisis, and has been exacerbated by the relative shortage of safe assets arising from multiple sovereign rating downgrades and unconventional monetary policies.
An examination of the historical evidence reveals that the conventional Wall Street wisdom which presumes a positive relationship between changes in debt and equity yields is decidedly misplaced. The truth of the matter is that bond and stock prices trend in the same direction only in disinflationary and inflationary regimes or roughly half the time.
In a deflationary regime, the financial assets part company as the lower risk premium attached to safe bonds is accompanied by a higher risk premium attached to stocks.
Investment practitioners continue to insist that lower treasury yields should result in higher equity valuations, even though debt and equity yields have moved in the opposite direction for more than a decade. Elevated inflation volatility and the increased deflation risk calls for structurally lower equity valuations, and not higher as the bulls seem to believe.
The astute will be aware that flawed thinking is bad practice.