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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 . . .

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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.

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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 | Comments (56) | TrackBack (1)
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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