What does “cyclicality would de-rate relative to certainty” mean?

Ah, diving into the deep end of financial theory, are we? Let's break this down:

1. Cyclicality would de-rate relative to certainty:

   • "Cyclicality" refers to the natural ups and downs in the economy and financial markets. Industries and companies that are cyclical tend to perform well when the economy is booming and poorly during downturns.
   • "De-rate" in this context means to reduce the relative value or rating of something.
   • "Certainty" here is likely referring to investments that have more predictable outcomes or less volatility, such as government bonds.
   • So, when Edwards says "cyclicality would de-rate relative to certainty," he's suggesting that in the market environment he's describing, investors would place a lower value on cyclical equities (stocks) compared to more certain and stable investments like government bonds. This is because the predictability of returns becomes more prized in a stagnating economy, which is what he means by "Japanification" – a reference to Japan's long period of economic stagnation.

2. Why would stock prices fall if bond yields fall too far?

   • Typically, lower bond yields can make stocks more attractive, as you've noted, because they reduce the relative appeal of bonds and can lead to a higher present value of future cash flows from equities, thus increasing their price/earnings (P/E) ratios.
   • However, if bond yields fall too far, particularly to very low levels, it can signal that investors expect economic growth to be very low or stagnant. This expectation of low growth can lead to a decrease in corporate earnings forecasts, which in turn can reduce the "P" or price in the P/E ratio, even if the "E" or earnings remain constant.
   • Additionally, extremely low bond yields might suggest that central banks are concerned about deflation or economic contraction, which are not good signs for corporate profitability and can lead to a reevaluation of the risk associated with equities, potentially leading to a fall in stock prices.

Remember, in the world of finance, the relationship between different asset classes can be complex and counterintuitive, depending on the broader economic context. It's like trying to predict where the banana peel will be on the sidewalk of the market – sometimes it's right in front of you, and other times it's nowhere to be seen. Keep studying and you'll get the hang of these slippery concepts!

Sources: A Decade Into IB: Teetering on the Edge of Cataclysm?, Bulls vs. Bears in 2018, The ‘Business Cycle’ framework, Will robots replace your consulting or financial career?, DCF Modeling Course ~ Pre-training text.pdf