Stock prices and the mean expected NGDP growth rate rose sharply last week, after losses for the prior two weeks. Inflation expectations climbed a bit further above the Fed’s preferred 2% target in core PCE terms, though the VIX declined. Apparently, markets are a bit more comfortable with higher inflation expectations, suggesting that monetary policy is somewhat looser.
Consistent with this conclusion are the most recent S&P 500 earnings yield forecasts. The forecasted earnings yield for the present quarter is actually below that of the previous quarter, despite higher projected earnings. However, as shown in the chart below, the earnings yield is expected to trend toward convergence with NGDP growth in coming quarters.
The adjusted earnings yield forecasts adds 6.7% to the explicit forecasts, to account for the 10-year mean tendency for analysts to underestimate earnings.
Comparing the Q4 2023 earnings yield estimate at 4.28% with the reported Q4 2023 NGDP figure at 5.82% demonstrates a rather large 1.54% positive output gap. Considering that the Fed’s GDPNow is at roughly 2.08%, figure in roughly 3% inflation, and the current output gap could easily be in excess of 1%. I would like to compare the Q4 2023 NGDI figure to that quarter’s NGDP figure, given the recent divergence of these metrics, but that NGDI figure is still unavailable.
As a reminder, the mean expected NGDP growth rate and the mean S&P 500 earnings yield are equal in the longer-run, consistent with an equilibrium relationship.
The logic behind this equilibrium relationship comes from neoclassical economics. The idea is that the mean NGDP growth rate should equal the mean growth rate of capital, in equilibrium. Using annualized concurrent quarterly, rather than trailing 12-month earnings, gives a more timely earnings yield.
Though the economy is still expected to slowdown and roughly approach equilibrium, monetary policy is currently at least a bit too loose. The Fed surprised me with their rather dovish statements last week, despite raising their inflation forecasts. They should have tightened policy a bit, perhaps by signaling a delay in the beginning of rate cuts versus expectations revealed in the Fed Funds Futures market.
So, there is more uncertainty now in the outlook for stocks and the economy, given this perplexing decision to loosen monetary policy. While I remain cautious about a further sharp upward trend in stock prices due to the state of inflation expectations, it seems the Fed might give the market more room to run. This could increase the likelihood of causing a recession at some point, if inflation eventually gets high enough to worry the Fed. This obviously increases the risk of a sharp downturn in stock prices at some point.
All we can do now is enjoy the ride, while not taking our eyes off the road.
Note: This post, as is the case with all my posts, should not be construed as offering investment advice. Such advice should be tailored to the individual investor by qualified professionals who, ideally, are fiduciaries.
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