Appaloosa Management founder David Tepper is the latest in a number of high-profile investors to sound a bullish note for equities. CNBC reports on an email by the investor, saying he is “still long stocks. Still short bonds.” That’s not too surprising for a hedge fund, but what’s interesting is his thinking behind that bet: “Why are stocks and bonds acting differently? It’s as if they’re reacting to two different economies.”
What does Tepper mean exactly, and what does this mean for retail investors?
For retail investors, it shouldn’t mean much. Remember that retail investors are best suited putting their money in the market over the long term and letting professional money managers do the analysis. For money managers, however, it means that the two markets that place macro bets on economic developments see the world differently.
To understand this rationale, let’s take a look at how each market is behaving.
Let’s start with stocks. The SPDR S&P 500 ETF (SPY) has gone up 21.4% in the last year:
That, in turn, has meant the S&P 500 P/E ratio has continued its now 7-year bull run:
Note that the run-up in prices has absolutely no correlation to changes in actual earnings:
Price gains have been drive by market enthusiasm and not fundamentals. That trend has continued in equity markets and has not stopped.
When will it stop? No one knows. But the important point is that there is no trigger now in the market to make that trend stop—which is why Tepper remains bullish.
Now let’s look at the bond side. U.S. Treasuries factor in two considerations in the price of Treasury yields: inflation and the growth rate. Treasuries are supposed to reflect the long-term rate of inflation and rate of real growth that an economy experiences. The higher the yield, the higher the expectations for long-term growth.
So it’s interesting to note that the 10-year Treasury rate has been going down for a decade:
We see at the tail-end of the chart an improvement in expectations, largely coinciding with the election of Donald Trump. But that doesn’t mean the market sees more growth—it could reflect more inflation expectations.
If we zoom into the last six months, that’s exactly what we see when we compare the Treasury rate’s jump to the University of Michigan’s Expected Changes in Inflation Rates Index:
So we don’t have a jump in bonds because of higher growth expectations, but in higher inflation expectations.
That isn’t just because of Trump, but because of the Federal Reserve. Janet Yellen has hinted at three rate hikes in 2017, which would drive the short-term Treasury rate to at least 1.25% within a year. Yet the 1-year Treasury rate is 0.8% and is actually falling from its peak in December 2016:
In other words, the market is less confident of the Fed actually raising rates as much as it threatens. Why? Because economic growth isn’t there and it isn’t expected to change radically in the future.
So there you have it. The bond market is not signaling economic strength, but the equity market is signaling market demand for corporate profits will continue to rise, even if those profits don’t rise themselves. Optimism in the stock market, pessimism in the bond market.