Investing--Dr. Yardini, Deutsche Bank:"The Fed’s Stock Valuation Model"
yardeni.com
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Edited for emphasis and ease of reading.
>>>Background On The Fed’s Stock Valuation Model
On December 5, 1996, Federal Reserve Board Chairman Alan Greenspan worried out loud for the first time about “irrational exuberance” in the stock market. He did it again on February 25, 1997.
He probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of this irrational exuberance.
Apparently, they did so and it was made public, though buried, in the Fed’s Monetary Policy Report to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on July 22, 1997.
The Fed model was summed up in one paragraph and one chart on page 24 of the 25-page document. (See insert on page 4.)
The Report’s chart shows a strong INVERSE correlation between the ratio of S&P 500 expected operating earnings—using 12-month-ahead consensus earnings estimates compiled by I/B/E/S International Inc.—and the 10-year Treasury yield.
Of course, in the investment community, we tend to follow the Price/Earnings ratio more than the Earnings/Price
ratio.
The ratio of the S&P 500 price index to expected earnings (P/E) is highly correlated with the reciprocal of the 10-year bond yield.
In other words, the “fair value” price is equal to expected earnings divided by the bond yield in the Fed’s valuation model.
The ratio of the actual S&P 500 price index to the fair value price shows the degree to which the market is overpriced or underpriced.
History shows markets can stay overpriced and become even more overpriced for awhile.
But eventually, such extremes are corrected in three ways:
1) falling interest rates,
2) higher earnings expectations, and of course
3) falling stock prices—the old fashioned way to decrease values.
A market that is underpriced can be corrected by rising yields, lower earnings expectations, or higher stock prices.
Interestingly, the Fed model shows that stocks were fairly valued at the end of 1996, not irrationally overpriced.
Stocks were 21% and 25% overpriced in the summers of l997 and 1998, respectively.
In September 1987, just prior to the October crash, stocks were 34% above fair value.
Immediately after the crash, stocks were about 10%underpriced.
They were consistently underpriced from 1993 through 1995.
Of course, theoretically, stock prices are equal to the present discounted value of future earnings (adjusted for risk), not just 12-month forward earnings.
The Fed model assumes that the market overwhelmingly weights expected earnings immediately ahead, and that earnings growth beyond the next 12 months is offset completely by risk assessments.
As demonstrated in this Topical Study, this is an empirically sound assumption.
The Fed’s Stock Valuation Model is a very simple one. It should be used along with other stock valuation tools.
Of course, there are numerous other more sophisticated and complex models.
The Fed model is not a market-timing tool.
As noted above, an overpriced (underpriced) market can become even more overpriced (underpriced).
However, the Fed model does have a good track record of showing whether stocks are cheap or expensive.
Investors are likely to earn below (above) average returns over the next 12-24 months when the market is overpriced (underpriced).<<< |
