A few days before I posted my latest market valuation update, an email arrived with the following question:

Your chart excludes long bond yields, whereas Robert Shiller includes this data in his spreadsheet. Do you exclude in order to prevent the chart from getting too busy? Or do you think interest rates are reflected in the chart indirectly, via the P/E ratio?

The reference is to the spreadsheet generously shared by Professor Robert Shiller on his Yale website. It includes a chart of the P/E10 ratio and the interest rate on 10-Year Treasuries, an earler version of which appears as Figure 1.3 in the opening chapter of his Irrational Exuberance. In the book Shiller points out the negative correlation between yields and the P/E10 ratio from 1982 to the market peak in 2000. But he also remarks that, over the long haul, the relationship between interest rates and the P/E ratio isn't very strong.

The chart I use in my regular market valuation feature does not include Treasury yields because my focus is the long-term correlation between the P/E10 ratio and market valuation. Adding the Treasury series introduces complexities beyond my topic, and it would be difficult to read atop the P/E10 quintile analysis. Also, since the correlation between the S&P Composite and the P/E10 ratio is so close, charting both against bond yields is a bit redundant.

The Market, Treasuries and Inflation
The Treasury yield chart I find most interesting is one that plots the 10-year constant maturity yield against the S&P Composite with inflation as a background reference. As the first decade of Boomers were being born (1946-1955), their parents were facing the final erratic volatility of post-WWII inflation/deflation. The deflationary low in 1949 was also the beginning of a secular bull market that reached its nominal and real peaks in 1966 and 1968, respectively (the latter shown on our chart).

But the decade of the 1960s witnessed the beginning of increasing surges of inflation that ultimately ended the secular bull market. Treasury yields continued to rise, reaching a peak at 15.3% in September 1981. But Fed Chairman Paul Volcker's policies triggered a reversal. He had raised the federal funds rate to 20% in June of 1981. The decade of stagflation was quickly ended, and by the summer of 1982 the market was at the starting gate of an 18-year bull run unprecedented in U.S. history.

Boom Times for Boomers
The amazing market advance from 1982 to 2000 was energized by the advent of tax-deferred savings and the gradual dismantling of private pensions. The 401(k) plan was introduced in 1980. The following year the Economic Recovery Tax Act permitted all employees, in addition to those not covered by an employee retirement plan, to contribute to an IRA. The result has been the massive growth of a new investor class with a limited understanding of markets and risk. The bulge of Boomers became a windfall for Wall Street (the oldest having just turned 35 in 1981). As I've pointed out elsewhere, corporate dividends began shrinking during this timeframe. The goal of retirement savings is to grow the nest egg. Thus, the distinction between dividend yield and price appreciation quickly lost relevance, and price appreciation trumped yield. Likewise, equities trumped Treasuries as Boomers entered their top-earnings years. In other words, we saw an inverse correlation between stocks and Treasuries.

The market peaked, in real terms, with the tech bubble of 2000. Equity prices have declined, but so has the Treasury yield. The familar inverse correlation of the 1982-2000 bull has disappeared. We're nine years into a secular bear market, and the future for investment is as uncertain as it has ever been.

Treasury Yield Minus Inflation
Here is a weird variant of our Treasuries chart — one that subtracts the annualized inflation rate from the constant maturity yield. The volatility prior to the advent of the Federal Reserve System in 1913 is amazing. Two World Wars separated by the Great Depression ensured a continuation of economic volatility but at a slower pace of oscillation.

By the mid 1950s, the pattern had changed dramatically. The decade of stagflation took its toll. But even in this chart version, the inverse correlation between equity growth and declining yields resembles the nominal Treasury yield chart.

The current financial crisis, now entering its second year, has introduced some unwelcome volatility in this alternate view. Nominal treasury yields are low, but after six months of deflation, the real yield has gone from negative territory (minus 1.6% in July 2008) to 5.7% one year later. Is this sudden "Treasuries minus inflation" volatility an anomaly, or are we entering a new phase of our economic history?

I plan to add this chart series to our list of regular features with periodic updates.