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US Equities Reach The “Death Zone” Versus Bonds

Instability continues as easing financial conditions weakens low inflation credibility.

Financial Conditions are now the easiest they’ve been in nearly a year. To put that into perspective, it means financial conditions are back to where they were BEFORE the Fed ended QE and began raising interest rates.
Gordon Long

“hopefully we learn to live with stable 3% to 4% inflation.”
Mohammed El-Erian

“Back in the day, they should’ve said 3% instead of 2%”
Kenneth Rogoff, former Fed economist

The Fed has been tightening interest rate policy for about a year, and bond yields have continued to rise significantly. Yet deficit spending, liquidity and other factors have boosted the financial conditions index to above where it was before the Fed switched to tightening policy.

Overall rising financial conditions have been supporting equity prices even as S&P 500 GAAP earnings are falling by around 29% year over year.

The divergence between bond yields rising and earnings yields falling has driven the S&P 500 Equity Risk Premium to extremes beyond 2008 levels into the clearly defined 110 year “death zone”.

What kind of losses could you expect on your equity portfolio?

The “Death Zone” for equities is an extreme in the US Bond/Equity Yield ratio shown below for over 100 years. The earnings yield on Equities is compared to Bond yields. Above 3.5 on the 10-yr Z-score makes Bonds as attractive relative to equities as they have ever been. The yield ratio has moved from opposite extremes in record time, with perhaps the only exception being 1929.

John Hussman has done great work on expected return norms for US equities.

At present, we estimate that a market loss of about -30% would be required to restore expected 10-year S&P 500 total returns to the same level as 10-year Treasury bond yields; about -55% to bring the expected total return of the S&P 500 to a historically run-of-the-mill 5% premium over-and-above Treasury yields; about -60% to bring the estimated 10-year total return of the S&P 500 to a historically run-of-the-mill level of 10% annually.
John Hussman

The US stock market suffered significant multiple contractions during prior inflationary decades. The CAPE ratio declined by in average ~50% in the 1910s, 1940s, and 1970s.   Today’s valuations are too high for how elevated cost of capital is with no real growth.
Tavi Costa

Current equity earnings reflect all time record profit margins achieved during the covid crisis.

Most investors seem unaware of just how abnormal valuations are today, as Wall Street earnings estimates take minimal account of likely earnings mean reversion.

Ultimately, to break the back of the current high inflation rates economic support policies will have to be at least removed if not reversed. The policy tightness required to get inflation durably down to anywhere near 2% will likely provide the catalyst for much lower valuations.

Just this week, Home Depot and Walmart guided 2023 earnings lower, and the equity market reacted the same day with the biggest fall of 2023 so far. These downgrades have a long way to go.

Retail Over-Spending Needs to Revert to Labor Market Capacity

“While most of the jobs recovery was hiring back employees that were let go, the surge in stimulus-fueled retail sales will ultimately revert to employment growth. The reason is that people can ultimately only spend what they earn. As shown, the disconnect between retail sales and employment is unsustainable.”

Some correction has already begun. In real terms retail sales are flatlining already but there is a long way to go.

Consumers Are Now Clearly Constrained

Consumer Credit Card Balances are at 20-year highs. The cost of that debt is also at multi-decade highs. The Consumer Savings Rate has hit multi-decade lows, and lastly, there’s already a 22-month streak of negative income growth.

Despite the signs of a weakening economy there seems no end to rising government deficit spending.

Government Deficit Spending Weakens Low Inflation Credibility

The latest CBO projections, with optimistic assumptions, indicates sizeable and expanding deficit spending indefinitely. There is very little push back on this characterization. Most official statements seem intended to downplay the key data and avoid addressing the issue.

Excessive deficit spending offsets monetary tightening in many ways. Interest costs need to be limited to contain the deficit, over spending can offset monetary tightening objectives, as does monetizing the debt as it boosts money supply. These issues have already caused problems in Australia and Japan.

If these issues are not addressed with government fiscal policy working together with monetary policy, this potentially requires the central bank to squeeze the private sector even harder to meet their anti inflation objectives.

Without fiscal and monetary coordination the central bank may find itself in an increasingly challenging and potentially impotent position.


The bond market is at the heart of economic and policy issues. The easing in the financial conditions index since October should be a concern for the Federal Reserve, which has slowed its interest rate rises and still has negative real interest rates, even though inflation is still a long way from its objective.

Although private sector demand has clearly weakened in important sectors, and commodity prices remain weak, it is not clear to what extent government fiscal policy is acting as an offset to central bank objectives.

This will need to be watched closely, and the current yield relationship with equities makes this crucial to the equity market too.

Confidence in achieving a durable 2% inflation objective is in decline.

Given the uncertainties Investors should consider incorporating options trading strategies to better reflect the uncertainties and manage the risks.

Transform Your Investment Experience

The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs Best Investor metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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