`Fed model's' worth in valuing stocks debatable
Gauge concludes S&P 500 stocks priced too low
chicagotribune.com
By Chris Graja
Bloomberg News
Published April 27, 2003
NEW YORK -- The stocks in the Standard & Poor's 500 index are 36 percent undervalued, or Wall Street analysts' profit estimates are too high.
It is possible to draw either conclusion from a method of valuing the U.S. stock market called the "Fed model" and cited by Federal Reserve Chairman Alan Greenspan. This approach compares the average earnings forecast for S&P 500 companies with the yield on 10-year Treasury notes.
The calculation suggests stocks are inexpensive even after the S&P 500's 10 percent rally since the end of September. Some investors, on the other hand, said the Fed model is misleading because it depends on expectations.
"Earnings estimates are delusionary," said Jay Compson, a money manager at Abington Capital LP, a Boston hedge fund. "I don't use the Fed model, and I don't know why it is used at all. There is more to valuing stocks than just the yield on 10-year notes."
Investors and strategists follow the Fed model. When stocks yield more in earnings than Treasuries pay out in interest, as they do now, the theory suggests equities may be cheap. If the yield is lower than the bonds' payout, stocks may be expensive.
Companies in the S&P 500 are expected to earn $55.03 per "share" of the index, according to the average analyst estimate compiled by Thomson Financial/First Call. That equals about 6 percent of the index level; 10-year U.S. Treasury bonds yield 3.93 percent.
Assuming analysts' profit forecasts prove accurate, the S&P 500 would have to be around 1400 to be fairly valued relative to bonds, based on the model. The benchmark index was about 36 percent below that value at Friday's close.
Year-ahead earnings forecasts typically are too high by 9 to 12 percentage points, according to First Call.
"Analysts' earnings estimates are probably a little too high," said Alex Motola of Thornburg Investment Management in Santa Fe, N.M. Still, his research is turning up more stocks worth buying, Motola said.
The firm recently bought Hughes Electronics Corp., which operates DirecTV satellite service, for the Thornburg Core Growth Fund.
The formula also can be used to determine investors' estimates of earnings, Edward Yardeni of Prudential Securities Inc. said in a note to clients, as opposed to what analysts are predicting.
If the S&P 500 is fairly valued at its current level, then investors expect earnings to drop 36 percent, to about $35.35 a share of the S&P 500. That's the level of earnings that will produce a yield equal to the 10-year Treasury. Wall Street analysts expect earnings to jump 12 percent.
Edgar Peters, chief investment officer of PanAgora Asset Management in Boston, tweaks the formula to account for the fact that analysts are too bullish.
Peters averages estimated earnings for the next 12 months and reported operating results for the previous 12 months. Even with his modifications, the model shows "the stock market is undervalued" by about 30 percent, he said.
Some analysts say the Fed model overstates the value of stocks when bond yields are as low as they are now.
The 10-year Treasury yield is down from an average of 6.66 percent in the 1990s. The lower yields go, the higher the implied value of stocks, yet stocks aren't necessarily worth more when the economy is slowing, as implied by a drop in interest rates.
Investors such as Peters said it is important to remember that the Fed model is a relative value tool.
"You can make a case that bonds are expensive," said Mark Keller of A.G. Edwards Asset Management. "If stocks are cheap relative to an expensive asset class, does that mean they are cheap?" |
