The so-called Fed model says stocks are cheap. Logic says otherwise
Fed model
The comparison doesn’t come out of the blue. It has a long tradition in finance, where it is known as “the Fed model,” because the ratio once appeared in a Federal Reserve report.
The argument is pretty appealing to many—especially now, when bond yields are so low. The stock market today sells for about 14 times forecast earnings—or, to put it another way, if you buy $100 worth of stocks, they should generate, or yield, about $7 in after-tax earnings. That’s on par with historical averages. But that 7 percent “earnings yield” looks enormous when compared with the pitiful 2 percent you’ll earn from 10-year Treasury bonds. Wall Street will offer data going back to the 1960s that shows the two yields moving in tandem.
At one level, you can compare the price of any investment with any other. Do U.S. stocks appear cheaper than European ones? Is timber cheaper than farmland? Warren Buffett, recently making the case for stocks, argued that they looked a lot more appealing to him than gold or bonds.
But can you make a direct mathematical comparison between the earnings yield on stocks and the yield on bonds, as the Fed model argues? Andrew Smithers, a respected financial consultant and the author of Valuing Wall Street, has a four-word reply: “It’s a con job.” He has studied the Fed model in detail. His conclusion: It isn’t supported by history, economics or logic. “It’s almost impossible to see how anybody who was in his right mind could hold that there was any validity to it,” he says, before adding, “unless, of course, he was trying to sell you shares.”
Hedge fund manager Cliff Asness, who has published research on the topic, agrees. People follow the model, he says, “but they do so in error.” What’s wrong with this model?
Consider what that means in practical terms. Bond yields are low today because the market is expecting very low growth and low inflation. But if that materializes, corporate earnings will rise more slowly than in the past, or may even fall. That’s grounds for caution, not optimism, about stocks. It’s also the case that today’s profit margins are near record highs. The only way earnings are likely to grow from here is if inflation picks up. If that happens, good luck with those bonds, whose prices would plummet.
When I heard someone pushing the Fed model recently, I started to think about overseas comparisons. By the model’s logic, in early 2008, both the Italian and Greek stock markets were an absolute bargain. Both sported earnings yields of about 10 percent, more than twice the yield on their country’s 10-year bonds. Oops.
There’s one more problem with the Fed model—and it maybe the biggest of all. It’s a relative-value trick.
Brokers aren’t saying stocks are actually cheap, only that they are cheap “relative to bonds.” But so what? I remember being told in the late 1990s that certain tech stocks were really cheap…compared with other tech stocks. From my window in Miami, I can see a vista of high-rise buildings where, just a few years ago, condos were marketed as a “bargain” compared with some of the others.
Are bonds fairly valued? By the standards of history, current yields on 10ominous chorus of smart people are lining up to warn that U.S. Treasury bonds are for lemmings. They include Jim Grant, of Grant’s Interest Rate Observer, who says they are in a bubble; Jeremy Grantham, chairman of fund shop GMO; and Paul Singer, head of the hedge fund Elliott Associates. Make of it what you will.
As for U.S. stocks? By various good long-term measures, such as 10-year average earnings, they certainly aren’t a steal. If your broker insists on pushing the Fed model, ask him why he isn’t pitching you Japan instead. The earnings yield there, about 8 percent, is eight times the yield on the 10-year government bond. By the Fed model, they must be a good deal—as, alas, they have appeared to be for a number of years.
© 2012 Daily Portal - Entertainment Site. All Rights Reserved
