Cheapest Stocks in Two Decades based on Flawed Fed Model
There is a fascinatingly bullish article on Bloomberg yesterday, titled Cheapest Stocks in Two Decades Signal Bull Market. Its all about the so-called Fed Model, and what it means for stocks.
A quick excerpt gives the full flavor of the article:
"BlackRock Inc., Fisher Investments Inc. and Schroders Plc, which manage about $1.4 trillion, say stocks are inexpensive relative to bonds. Profit of companies in the Standard & Poor's 500 Index, the benchmark for American equity, is growing faster than shares, and represents a yield of 6.53 percent compared with 4.65 percent for 10-year U.S. Treasury notes.
The gap -- the widest since 1986, according to data compiled by Bloomberg -- is encouraging investors because earnings forecasts indicate the U.S. will keep growing, while bond yields show confidence that inflation will stay in check."
There is a few problems with this sort of analysis: The biggest problem with the so-called Fed model is that its built on two assumptions: 1) That profits will stay high, despite being a cyclical peak and decellerating; and 2) that interest rates will stay low. If either of these variables move off their present readings by a significant amount, cheap stocks suddenly look a whole lot less cheap. (my view on valuation is that, based on the S&P500 earnings, stocks are neither cheap nor expensive. Regardless, bigger stocks are cheaper than smaller stocks).
The second issue is that Fed model double counts low interest rates. How? When rates are low, the cost of borrowing drops, allowing companies to finance cheaply, retire debt etc. Those savings and gains show up in earnings. That's certainly what has been going on the past few years. If the next next step in your analysis is to then compare those earnings gains and valuation to Treasury yields, you are simply counting the impact of low rates two times.
The last problem with the so-called Fed model is that I’ve never seen a proof that this is determinative or predictive of future market performance. When stocks became expensive via the model in the mid to late 1990s, they managed to rally another 3 years before finally rolling over.
If anything, the Fed Model teaches us that Valuation is a rather imprecise timing tool . . .
>
UPDATE: April 3, 2007 9:22am
As we have previously noted many, many times, P/E ratios go through periods of cyclical expansion and contraction. The expansion of P/Es during the 1982-2000 bull market was responsible for 75% of market gains; The present contractionary P/E cycle is partly responsible for the lowering the P/E of most stocks.
Miller Tabak's Peter Boockvar reminds us that according to the Fed Model, in 1981 stocks with depressed earnings and sky
high interest rates were crazy expensive -- just as the greatest bull market in US history began.
>
Sources:
Cheapest Stocks in Two Decades Signal Bull Market
Michael Tsang, Daniel Hauck and Nick Baker
Bloomberg, April 2 2007
http://www.bloomberg.com/apps/news?pid=20601109&sid=aIEj7C7IEUeI&
The Fed Model: Fix It Before You Use It
Jonathan Clements
WSJ, May 1, 2005
http://online.wsj.com/public/article/0,,SB111491292409921442,00.html
Tuesday, April 03, 2007 | 07:09 AM | Permalink
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Yesterday' we took note of the Bloomberg story, Cheapest Stocks in Two Decades Signal Bull Market, which quoted several large and successful fund managers. This story stimulated a post from Barry Ritholtz at the Big Picture, where he said that [Read More]
Tracked on May 7, 2007 10:21:15 AM
Comments
In addition, they used deceptively optimistic “operating earnings” or excluding expenses pro forma earnings; using real GAAP S&P P/E’s the stocks are not that cheap. Moreover, they ignored the risk premium associated with stocks (bonds and stocks are not equal when it comes to risk; nevertheless, they compare apples (stocks) to oranges (bonds) like equals)
Posted by: V L | Apr 3, 2007 7:51:24 AM
Also, what are the quality of those earnings. How much in charges and option expenses are ignored?
Posted by: dave | Apr 3, 2007 7:58:26 AM
The Fed Model is not a forecasting model. It's an arbitrage relationship between future path of the short term interest rate and future earnings. It helps you to link your macro forecasts (GDP, Inflation, short term interest rate) with future stock market performance.
~~~
BR: I am not sure that is the most precise usage of the word "arbitrage"
Posted by: mdbllbr | Apr 3, 2007 8:00:18 AM
The Fed model says more about the price of bonds than the price of stocks. However, it does explain why buybacks are so prevalent; earnings yield on equity is higher than the yield that companies can get on deposit, in Treasuries, or, for investment grade corporates, from buying back their own debt.
Posted by: Macro Man | Apr 3, 2007 8:07:47 AM
Did the model consider these facts?
"... Share prices have been propped up by debt during recent stages of this rally. Debt has funded corporate buybacks of shares, and those buybacks have made specific stocks look more attractive (fewer shares outstanding means higher earnings per share, since the earnings get spread over fewer shares) and supported the stock market in general by reducing the supply of shares and adding to earnings growth. Debt has funded dividends. Yes, I know dividends are supposed to come out of earnings, but recently many companies have discovered that it's easier to simply borrow the money in order to pay it out to investors. In that way, too, debt has supported stock prices by making dividend growth look better..."
http://articles.moneycentral.msn.com/Investing/JubaksJournal/IPOMarksEndOfTheCheapDebtEra.aspx
Posted by: V L | Apr 3, 2007 8:11:57 AM
Probably not, because it's not true. US corporates have large net cash positions and financial leverage is low.
Posted by: Macro Man | Apr 3, 2007 8:31:27 AM
To extend your point about double-counting interest rates: a rate of '0' would obviously be ideal. The model does not consider that there may be reason why that rate might lead to other dificulties... say, a bubble economy, for instance.
Posted by: wally | Apr 3, 2007 8:49:04 AM
In my view there are two items worth investigating further: first, "profits are rising faster than shares" - this is a little misleading as buybacks have reduced shares and profits are not rising but beginning to trend downward; second, "bond yields shows confidence that inflation will stay in check" - the ability of the bond market to predict inflation may well have been substantially reduced by the demand for bonds created by the negative trade deficit.
Posted by: Winston Munn | Apr 3, 2007 9:06:52 AM
I find it interesting that 3 companies that manage $1.3 Trillion are going out of their way to tell Joe Retail that stocks are cheap and he should buy. What would these companies have to gain from this?
And of course if you name drop, like Fed Model, you are sure to get some reaction. Forget negative savings, high inflation, decelerating earnigns, the myth of forward PE, and the tapped out consumer.
The problem is the consumer is so tapped out, they are taking money out of the market (their savings plan called a 401k) and using it to pay their mortgage.
Posted by: Josh | Apr 3, 2007 9:10:50 AM
"BlackRock Inc., Fisher Investments Inc. and Schroders Plc" are smart guys to really believe in the misleading B.S. they are spreading. (They know it)
It makes me wonder if it is an exit strategy for them. (Dumping their shares to Joe)
Posted by: V L | Apr 3, 2007 9:21:38 AM
I guess we had to have a comedy piece did''nt we??
Seriously what's missing in any analysis is the quality of earnings, if a company beats expectations it seems no one looks to the real reason like say a tax benefit or similar. Just that they "beat"....I see no reason why that trend will not continue. Fisher, Draper et al have quite the motivation to be bullish since bad news does'nt sustain money flow into thier funds.
AS someone posted previoulsy companies will make the numbers, especially in the short term since all they have to do later on is say we've uncovered "accounting issues" and then re-state...and the stock acts as if the "fakey" numbers were real even after they've stated the truth- well what they say is the truth.
Pretty disturbing also how all of a sudden the market soars (futures-at least) on on "easing of tensions"...too bad it did'nt drop much on the escalation of the same "tensions".......
Spin in full effect..
Ciao
MS
Posted by: Michael Schumacher | Apr 3, 2007 9:22:50 AM
"Europe has eclipsed the US in stock market value for the first time since the
first world war in another sign of the slipping of the global dominance of
American capital markets. Europe's 24 stockmarkets, including Russia and
emerging Europe, saw their capitalisation rise to $15,720bn (€11,819bn) at the
end of last week, according to Thomson Financial data. That exceeded the
$15,640bn market value of the US."
From Morgan Stanley today
Posted by: traderb | Apr 3, 2007 9:23:27 AM
I'm glad you touched on the fed model as I read the Fisher piece too. If they had used the fed model in 1981, stocks with depressed earnings and sky high interest rates, they would have declared how crazy, expensive stocks were just as the greatest bull market in US history began.
Posted by: Peter | Apr 3, 2007 9:30:38 AM
By far the best work done on debunking the idiotic [and it is idiotic] Fed model has been by Cliff Asness at AQR. Go to their website or google him to find his research.
My much simpler retort is always as follows: If long rates dropped to 1%, does that mean stocks should trade at 100 PE and equities would make tons of money? Of course not--just ask the Japanese.
Posted by: Jay Weinstein | Apr 3, 2007 9:45:29 AM
BTW, I think the quality of earnings is better than they have been in many years . . .
Posted by: Barry Ritholtz | Apr 3, 2007 9:46:37 AM
Barry, I've said it once on these boards and I'll say it again: if you wish to do your readers a great service, discuss current P/E ratios in terms of P/multi-year moving average of E. Graham suggested using no less than 7 years of earnings; Robert Shiller suggests 10 years. This method smooths out brief dips or spikes in corporate earnings and gives you a better sense of where valuations are.
Posted by: Adam | Apr 3, 2007 9:46:54 AM
Well,
1. Bonds do not "predict" inflation, they follow it. Obviously.
2. Comparing "earnings yield" (a number on a piece of paper that may or may not represent real cash, may or may not find its way to the shareholder's pocket, and may or may not be there tomorrow) with a bond dividend (a guaranteed cash payout on a guaranteed principle investment) sounds exactly the way it sounds - rather ignorant.
3. A technical point could also be made that using an investment with one duration as a benchmark of an investment with a considerably different duration is invalid.
Small Investor Chronicles
Posted by: Alex Khenkin | Apr 3, 2007 9:47:13 AM
BR-
I can't disagree with your statement that they have been better however one must look at where you started from to arrive at that opinion. If earnings quality is at, say 10%, (just using numbers to illustrate) and it "rises" to 20% the percentage increase is wonderful however 20% is still pretty poor overall and does'nt really support that they are any better....all in where you begin.
How was the game?
Ciao
MS
Posted by: Michael Schumacher | Apr 3, 2007 10:00:04 AM
http://www.safehaven.com/article-7250.htm
At this above address you may find a documented analysis on corporations borrowings as compared to capital expenditures or alternatively stocks purchases.
Equities are not expensive if purchased through derivatives and require more thoughts when paid in cash.
This article of Bloomberg was published around....April 1ST day where you may have more imagination than reality oblige.
Posted by: Philippe | Apr 3, 2007 10:01:09 AM
Bashing this model is akin to bashing a PEG ratio, or PE analysis, etc. It cannot be viewed in a vacume. It is a relative value tool -- showing where $$ is being treated the best. As Macro Man suggests, this explains why there is so many buybacks. It certainly is not a timing tool...but looking back on the bubble, it was obvious that bonds were a better deal than stocks at the peak! You couldn't give away zero coupon bonds in 2000!!!
Posted by: Fred | Apr 3, 2007 10:04:28 AM
John Hussman also does an excellent job at debunking the Fed Model.
http://www.hussmanfunds.com/
BTW, John relates current P/E ratios in terms of Price to Peak Earnings
Posted by: glenn_in_MA | Apr 3, 2007 10:06:11 AM
As Alex implied, a much better analytical measure to compare equities with corpoates is free cash flow yield per share.
On another note, I wonder how undervalued the Nikkei is using the FED model, with 10-year JGB's yielding 1.7%?
Posted by: S | Apr 3, 2007 10:55:42 AM
P/B ratios sure don't look cheap and insiders are dumping stock at close to the highest level ever. Gee....I wonder why?
Posted by: lloyd | Apr 3, 2007 11:08:59 AM
Today's "rally" should be named the David Lereah Market Assumption rally......
No one reads any longer.....
Ciao
MS
Posted by: Michael Schumacher | Apr 3, 2007 11:10:42 AM
I dont know but this market is rockin n rollin today. Up there near the highs before that february 28 selloff. wow! How high can we go?????!!!!!! awesome!
Posted by: mark | Apr 3, 2007 11:15:53 AM
