September 23, 2004

Two epistemologies, financial edition.

"One of these things is not like the other":
Investors in stocks and bonds view the world differently. Bond investors tend to be suspicious and pessimistic by nature. They accept lower potential gains in exchange for lower potential losses. Bonds guarantee at least an interest payment, and government bonds are backed by the full faith and credit of the most powerful nation in world history. Stock investors are by nature optimistic, even credulous. Stocks are about stories, future growth, and earnings estimates. They are backed only by the full faith and credit of highly fallible CEOs.

So it's natural that there would be some disconnect between the two groups. But the two markets usually have roughly the same view of the economy. Crudely speaking, when the economy is running hot, you'd expect the prices of stocks to rise and the prices of bonds to fall. When it's sputtering along, you'd expect the prices of bonds to rise and the prices of stocks to fall. Today, however, the bond and stock markets seem to inhabit different worlds. They are about as polarized as the American electorate.
Alas, no word on which set of traders we should believe. If you look at the chart Kash set up, though, you see that 10-year bond yields have predicted employment growth fairly well over the last five years. The stock market hasn't predicted things nearly as well. Why? My guess is that bond traders pay closer attention to "pure" macroeconomic indicators, while stock traders have other things in mind. Maybe a bunch of them have serious short positions. Maybe a tiny number of investors are swinging the market (a tiny number of investors usually can), for whatever reason, even as price/earnings continues to lag. Maybe. I wish someone smarter than me -- like, hey, Daniel Gross! -- would follow up with a little more digging.
-- Brad Plumer 1:51 AM || ||