Bond and Equity Yields -- 35yr Correlation Breaking down?

With all the debate about whether economic growth will be a V, a W, a square root, etc there have been a number of articles recently noting the market, unlike earnings, isn’t (or at least hasn’t) been particularly correlated with the economic cycle.   For anyone who’s ever looked at graphs of S&P and of S&P earnings, like the one below, that’s pretty undeniable.

However, that’s not the graph that Our Man wants to focus on today.  Instead, let’s look at a correlation that has lasted so long that it’s now almost an automatic assumption for investors; that between bond and equity yields.

 

As we can see by using both of the graphs, there have been 2 very clear patterns:

1965-1982: S&P going sideways, as profit growth is offset by multiple compression
1982-2000: S&P rising driven my multiple PE expansion
To put this 20-year multiple expansion into context, if the 03/00 peak had been at 1982’s 8.47x PE10, it would have been at a far less bubblicious S&P level of 545!  And it’d still be below that today…

As a further aside, Our Man is sure he isn’t the only one who has noticed the greater prominence of investors’ touting their “value investing” and other fundamental stock-picking tenets, over the last couple of years.  This should come as no surprise; the relatively steady Earnings Yield of c4% between mid-03 and mid-08 would imply a stock-pickers market where investor returns are driven far more by a an ability to understand a company’s fundamentals than by other factors.

However, though the Equity and Bond Yield relationship is largely ingrained in investor psyche, it is actually a new phenomenon and it hasn’t always been this way:

 

Evidence from Japan, where equities and bonds have noticeably decoupled since the 90’s, would suggest that things are perhaps returning towards their historical lack of correlation.  It also leads Our Man to ponder… that while we may have been able to create this relationship through our focus on rates as a monetary tool…will it still exist should using interest rates loses its primary role (due to a zero-interest rate policy) and effectiveness as monetary tool.

If so, Japan gives us a hint at what Our Man is looking for in equity world:
- Equity performance to tie more closely with the economic cycle
- Leading indicators (and especially their bottoming out and topping) to provide a broadly helpful sign of when and when not to take significant directional exposure
- Finally…a probable derating of equities. 
Why?  Predominantly as a greater risk premium should be introduced by investors to account for the more cyclical nature of equities but also due to investors’ long-term expectations proving overly ambitious (due to the deflationary/disinflationary environment limiting pricing power).