Here’s a Puzzle

Felix Salmon points to this chart, which is a head-scratcher:

[F]rom 1985 through about 2002, it was just as common for the S&P earnings yield to be lower than the Treasury yield as it was for the yields to be the other way around…

In 2002, everything changed. The spread between the two jumped up to a very high level and stayed there, all the way through the onset of the financial crisis. This was the Great Moderation.

He can’t figure it out but concludes that it must mean it’s time to buy stocks. I’m too much of a believer in EMH to think that it’s that black-and-white.

Here’s a follow-up that peels away all of the apples-and-oranges issues from comparing government debt to corporate equity.

We’ve elminated a lot of the gap. Now what is probably the answer is becoming clear.

Nick Rowe focuses on the fact that stocks are more ‘real’ and less ‘nominal’ than bonds. I like this explanation a lot. I predict, then, that there should be no gap unless the market misestimates inflation.

So let’s eyeball-shift that graph.

Imagine that blue line nudged up by expected inflation all the way back. There’s probably a reverse gap in the 60s and 70s (high and rising inflation? Check) and a lockstep march downwards during the Great Moderation (predictable disinflation? Check.).

And today? Today we’re staring down the barrel of deflation, folks. No more shift. No gap.

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