Ken: In this vein, an article appearing in the 16 March 1998 Barron's
is, in a word, provocative. It seems that a stock market valuation
model used by the Federal Reserve has been unearthed by Ed Yardeni,
economist for Morgan Grenfell, who found it buried in the back pages
of a Fed report. The model is based, according to Barron's, on a
comparison of the yield on the 10 year Treasury notes to the price/
earnings ratio of S&P 500(employing 12 month projected earnings).
Interestingly, the model uses a so-called "earnings yield on stocks"
for comparison to the 10 year note. The earnings yield is the inverse
of the price to earnings ratio. Therefore, in the present instance
of an S&P 500 at 1079 odd and projected 12 month earnings at
$50.78(using current IBES Int'l estimates) the earnings yield on
stocks would equal 4.70%. The 10 year Treasury note currently earns
about 5.54%. To paraphrase Barron's, "The model asks why anyone
would buy stocks with a 4.70% yield when they could get a bond with
a yield of 5.54%?" Using these numbers, the model would suggest
the S&P 500 should be trading at 916, instead of 1079, or, put
another way, the current market is 18% overvalued. As Yardeni
asserts, "The market is as overvalued now as it was before it
took a dive in October (1997)."
The Federal Reserve model, per the graphs accompanying the
Barron's article, "has done a pretty good job of predicting the
path of the S&P 500 over the past 18 years."* Believing the IBES
estimates of $50.78 for S&P 500 earnings too optimistic, Yardeni
states, "I think we'll be lucky to do $48. If you use $48, the
market is about 25% overvalued." Indeed, factoring in a 10 year
note yield of 5.54% and earnings of $48 for the S&P 500, the Fed
model suggests a market fairly valued at 866 on the S&P 500,
instead of the present 1079.
Meanwhile, Yardeni admits that the market "can remain overvalued
for quite some time" and that overvaluation can be corrected by a
fall in interest rates and/or a rise in profit estimates. Parentheti-
cally, one need only to refer to the Japanese market experience of
some years ago to make the case that unseemly overvaluation can
endure for lengthy periods. On the other hand, as reported on this
thread prior, Yardeni, the raging bull of the 1980's/90's has turned
markedly cautious, partly due to expected Year 2000 computer
problems, and counsels that "the days are numbered for this bull
market."
* "The point of most extreme overvaluation came just before the
crash of 1987, when stocks were 32% overvalued (per the Fed
model)."
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