Sunday, June 12, 2016

Lower Bond Yields, Lower Earnings, Higher Equity Prices?

Another sign that I have no idea what's going on with Mr. Market these days (or ever):

Bond prices continue to go higher, driving yields lower. Some are already trading with negative yields. This might be due to central bank influence, general risk-aversion, or lower inflation (or growth) expectations or a combination of such.
Corporate profits continue to drop. The latest figures show that trailing-twelve month profits peaked at 106 in Q3 2014. Most recent figures were ~86.5 for Q1 2016. That's close to a 20% drop.
On the other hand, US equity markets are making new highs. Looking at the S&P 500, you wouldn't have noticed the decline in profits. In fact, since Q3 2014, the S&P has actually gone up another 100 points or so, gaining well over 5%. Equity markets seem to believe that either discount rates will go lower, or earnings have stabilized and will rebound from this point. (Both of which are possible.)

One explanation might be the central bank's actions pushing investors toward riskier assets. Holding all else equal, this make sense. By effectively reducing the risk-free rate, and hence, discount rate, asset prices should go higher.

In this case, however, all else may not be equal. That's because the reason for all this monetary stimulus is that economic conditions are weak. So while discount rates are lower, the expected earnings growth may also be lower. Given the two adjustments, it's unclear to me whether equity prices should be higher, lower, or flat.

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