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If you haven't been living under a rock lately, you know that Treasury yields are low. Very, very, very, low.
In fact they're now so low that the U.S. government can borrow at -0.01% in real terms, as of this writing, for 20 years. That means people are literally paying the government to take their money from them for the next 20 years. If you, too, feel like paying the government to take your money, you can easily invest alongside them in the $23 billion iShares Barclays TIPS Bond (NYSE: TIP ) exchange-traded fund.
So is this a good or bad sign for U.S. stocks? The answer is -- like most things in economics -- it depends.
The slightly more bearish scenario: The market is right and we're Japan
Japan has been in a multidecade economic slump. Because of this, the island nation has been able to borrow money at extraordinary low rates -- despite cries of a bond bubble -- for almost 20 years now. If the Treasury yield curve is to be believed, the U.S. will experience something close to Japan's economic horror.
As terrible as this fate may be (and it is terrible for the unemployed), it doesn't necessarily kill the case for U.S. equities. As Morgan Housel points out, economic growth and equity returns historically haven't been that linked. This is because equity valuations tend to fall to meet lower growth expectations, helping subsequent returns.
But that makes you wonder: Why are investors willing to settle for the negative real returns of Treasuries? Why aren't they more willing to invest in stocks, especially when they seem unusually cheap in comparison?
It could be they are very much willing to invest in stocks, and that stocks are also priced for low returns, consistent with low Treasury yields.
Don't follow? The SPDR S&P 500 (NYSE: SPY ) ETF currently trades at 13.16 times 2012 forecast earnings. At first this seems excellent, but consider that profit margins are at record highs -- almost 70% higher than the mean. Profit margins tend to mean revert over time, which means that earnings may be unsustainably high. If the market is factoring that in its valuation calculations, stocks may be properly priced for mid- to low-single-digit returns, which is consistent with low Treasury yields. That's not terrible, but not terribly exciting either.
The most bearish scenario is if the market is suffering from what I call "multiple personality disorder." That's where the Treasury market and the stock market are pricing in two completely different scenarios -- the Treasury market a terrible economy, the stock market a bullish economy -- and the Treasury market is the correct one. In that case, stocks would need to fall to the meet the proper economic reality. I find this scenario unlikely given equity valuations, but it's a possibility.
The slightly more bullish scenario: The market is wrong and we're not Japan
Now let's say the market is wrong, and we're not Japan.
What happens to bonds is easy -- real rates go up, inflation probably goes up, too, and bonds collapse in price. This is the "bond bubble" popping scenario. If this happens, my bearish CAPScall in Vanguard Extended Duration Treasuries (NYSE: EDV ) makes beaucoup bucks (err... points). I'd also expect the most bond-like stocks -- like the high-yield, limited retained earnings, U.S. tobacco giants Reynolds American (NYSE: RAI ) and Altria (NYSE: MO ) -- to suffer alongside bonds.
What happens to stocks is a bit murkier. A rise in real rates would be bad for stocks. At the same time, a better economy would aid earnings growth, which would be good for stocks. Inflation -- if not 1970s bad -- would be a wash, as companies (especially good ones) can raise prices with benign inflation.
The best scenario for stocks would be the "multiple personality disorder" scenario I discussed above, but in reverse and with a twist: The economy improves but the stock market has already priced in a rise in real rates -- so stocks don't have to fall when rates rise -- but hasn't already priced in an increase in earnings growth. I find this scenario unlikely, however, as it would require the stock market to have successfully forecast one part of a recovery (a rise in real rates) but not the latter, a rise in earnings growth.
Confused? You should be
As you can see, it's not a slam dunk to conclude what will happen to stocks based on Treasury yields and different economic conditions. This is why a bottom-up stock-picking approach, or a buy-and-hold indexing approach, is generally one most Fools recommend. The greatest investors, such as Peter Lynch and Warren Buffett, tend to ignore the macroeconomic confusion altogether. You'd be wise to follow their example.