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In light of all the darkness, and who knows what the coming months will bring, I thought I would take a moment to step back and have a little look at the market from a 10,000ft view. Of course things are absolutely dismal. I am not sure there is one good sign out there.

Comment on Inflation

I noticed that the Producer’s Price Index (PPI) rose 0.8% and the Consumer Price Index (CPI) rose 0.3%. I am not really sure if that is a good sign or not. For those saying inflation is going to be a huge problem in the coming years, I suppose this is a good thing. For others insistent upon this being a period of deflation, I am led to believe this must be a bad thing.

At the very least, when PPI rises faster than CPI, this puts pressure on producer margins simply because their cost of goods sold is rising faster than they are able to pass through to consumers. Obviously this is a bad thing for producers. It isn’t a good thing for consumers either, simply because prices are still rising.

I doubt this is a good thing for the Federal Reserve, considering it puts their already precarious position of tremendous monetary expansion into an even trickier situation. This might very well be a one off event, but on the other hand if this inflation persists and even grows, the Fed will be either forced to raise interest rates thereby stomping on an already dreadful economy or the Fed will just have to sit tight and watch inflation (as well as inflation expectations) rise until such time as the economy begins to show some signs of improvement.

Stock Market Valuation

I trust the majority of readers on this website have at least heard of the “Fed Model”. In essence this is an asset allocation model that hopefully provides evidence as to the value of stocks relative to bonds. There is much debate on whether or not the model is accurate or not, and I don’t intend to prove the merits of it here. I will however present a few statistical points on what the Fed Model suggests about stocks currently.

Table 1, shown below, is the Fed Model for 1960-1984. For those of you less familiar with the model, the Fed model relies upon the earnings yield minus the 10 Year treasury yield. The two columns of most interest to this article are the “Spread” and the “S&P 500”. The column called Spread is the S&P Earnings yield minus the 10 Year Treasury yield. The S&P 500 Column is the 1 Year stock market return without incorporating dividends.


Table 1.

Fed Model from 1960-1984

Year

Earnings Yield

Dividend Yield

S&P 500

Earnings

Dividends

10 Year Yield

Spread

S&P 500

1960

5.34%

3.41%

58.11

3.1

1.98

3.84%

1.50%

-3.02%

1961

4.71%

2.85%

71.55

3.37

2.04

4.06%

0.65%

20.81%

1962

5.81%

3.40%

63.1

3.67

2.15

3.85%

1.96%

-12.57%

1963

5.51%

3.13%

75.02

4.13

2.35

4.14%

1.37%

17.30%

1964

5.62%

3.05%

84.75

4.76

2.58

4.21%

1.41%

12.20%

1965

5.73%

3.06%

92.43

5.3

2.83

4.65%

1.08%

8.67%

1966

6.74%

3.59%

80.33

5.41

2.88

4.64%

2.10%

-14.03%

1967

5.66%

3.09%

96.47

5.46

2.98

5.70%

-0.04%

18.31%

1968

5.51%

2.93%

103.86

5.72

3.04

6.16%

-0.65%

7.38%

1969

6.63%

3.52%

92.06

6.1

3.24

7.88%

-1.25%

-12.06%

1970

5.98%

3.46%

92.15

5.51

3.19

6.50%

-0.52%

-0.07%

1971

5.46%

3.10%

102.09

5.57

3.16

5.89%

-0.43%

10.27%

1972

5.23%

2.70%

118.05

6.17

3.19

6.41%

-1.18%

14.66%

1973

8.16%

3.70%

97.55

7.96

3.61

6.90%

1.26%

-19.07%

1974

13.64%

5.43%

68.56

9.35

3.72

7.40%

6.24%

-35.27%

1975

8.55%

4.14%

90.19

7.71

3.73

7.76%

0.79%

27.42%

1976

9.07%

3.93%

107.46

9.75

4.22

6.81%

2.26%

17.52%

1977

11.43%

5.11%

95.1

10.87

4.86

7.78%

3.65%

-12.22%

1978

12.11%

5.39%

96.11

11.64

5.18

9.15%

2.96%

1.06%

1979

13.48%

5.53%

107.94

14.55

5.97

10.33%

3.15%

11.61%

1980

11.04%

4.74%

135.76

14.99

6.44

12.43%

-1.39%

22.93%

1981

12.39%

5.57%

122.55

15.18

6.83

13.98%

-1.59%

-10.24%

1982

9.83%

4.93%

140.64

13.82

6.93

10.36%

-0.53%

13.77%

1983

8.06%

4.32%

164.93

13.29

7.12

11.82%

-3.76%

15.93%

1984

10.07%

4.68%

167.24

16.84

7.83

11.55%

-1.48%

1.39%

Table 2, shown below, is the Fed model from 1985 through 2008 and an estimate for 2009. To arrive at the estimate for 2009, I simply made an assumption that the S&P 500 earnings were going to fall from 65.39 in 2008 to 48.75 for 2009. This represents a 25% reduction in 2009 y/y earnings. This is also somewhat consistent with the more bearish views out there.

Table 2.

Fed Model from 1985-2009

Year

Earnings Yield

Dividend Yield

S&P 500

Earnings

Dividends

10 Year Yield

Spread

S&P 500

1985

7.42%

3.88%

211.28

15.68

8.2

9.00%

-1.58%

23.38%

1986

5.96%

3.38%

242.17

14.43

8.19

7.23%

-1.27%

13.64%

1987

6.49%

3.71%

247.08

16.04

9.17

8.83%

-2.34%

2.02%

1988

8.20%

3.68%

277.72

24.12

10.22

9.13%

-0.93%

11.69%

1989

6.80%

3.32%

353.4

24.32

11.73

7.92%

-1.12%

24.10%

1990

6.58%

3.74%

330.22

22.65

12.35

8.06%

-1.48%

-6.78%

1991

4.58%

3.11%

417.09

19.3

12.97

6.70%

-2.12%

23.35%

1992

4.16%

2.90%

435.71

20.87

12.64

6.70%

-2.54%

4.37%

1993

4.25%

2.72%

466.45

26.9

12.69

5.79%

-1.54%

6.82%

1994

5.89%

2.91%

459.27

31.75

13.36

7.82%

-1.93%

-1.55%

1995

5.74%

2.30%

615.93

37.7

14.17

5.58%

0.16%

29.35%

1996

4.83%

2.01%

740.74

40.63

14.89

6.42%

-1.59%

18.45%

1997

4.08%

1.60%

970.43

44.09

15.52

5.73%

-1.65%

27.01%

1998

3.11%

1.32%

1229.23

44.27

16.2

4.65%

-1.54%

23.64%

1999

3.07%

1.14%

1469.25

51.68

16.71

6.44%

-3.37%

17.84%

2000

3.94%

1.23%

1320.28

56.13

16.27

5.10%

-1.16%

-10.69%

2001

3.85%

1.37%

1148.09

38.85

15.74

5.03%

-1.18%

-13.98%

2002

5.23%

1.83%

879.82

46.04

16.08

3.82%

1.41%

-26.61%

2003

4.87%

1.61%

1111.91

54.69

17.88

4.26%

0.61%

23.41%

2004

5.58%

1.60%

1211.92

67.68

19.407

4.22%

1.36%

8.61%

2005

5.47%

1.79%

1248.29

76.45

22.38

4.40%

1.08%

2.96%

2006

6.18%

1.77%

1418.3

87.72

25.05

4.71%

1.47%

12.77%

2007

5.62%

1.89%

1468.36

82.54

27.73

4.04%

1.59%

3.47%

2008

7.24%

3.11%

903.25

65.39

28.05

2.24%

5.00%

-48.59%

2009

6.41%

760

48.75

2.84%

3.57%


Before I move to the next part of the discussion let me go ahead and put a disclaimer out there right now. Investors should not exclusively rely on the Fed Model to allocate their portfolio to stocks. For that matter there is probably not any single model that any investor or institution should exclusively rely upon for portfolio allocation.

A few simple statistical observations reveal some interesting characteristics of this model. After ranking the spreads for the previous 50 years, 2009 is in approximately the 94 percentile in cheapness. That is after assuming a 25% drop in earnings from 2008 levels. Put quite simply stocks are cheap by historical standards using the Fed Model. Does that mean that stocks won’t get cheaper? Of course it doesn’t. In fact I would be more inclined to make an ad-hoc argument that stocks will very likely get cheaper until positive catalyst in the U.S. take effect. Does that mean investors should simply wait until the stock market starts roaring higher with the advent of policy makers who actually know what they are doing? Waiting for underlying economic data to turn robustly positive is probably not the right answer either.

Interestingly enough, investors who bought the S&P 500 and held it for three years following the Fed Model reaching a spread of 3% or greater realized returns of 32.7% from 1975 through 1977, 35.6% from 1977-1979, and 26.5% from 1980-1982. Granted the annualized returns are certainly not as spectacular simply because you are talking about returns over 3 year periods. But nonetheless, for the typical investor, these are fine returns.

Candidly we are off to a bad start in 2009, but there is still a vast majority of the 3 years remaining. Please recall, I am assuming a 25% y/y reduction in earnings for the S&P 500 in my analysis. This may or may not come true and of course the earnings could fall much further than 25% y/y.

Stocks are cheap but that doesn’t mean this is a bottom – not even close. We need a catalyst. Other countries are taking measures that seem to be more constructive than our own. Maybe sooner rather than later, the President and his staff will take the time to think things through rather than give a pretty speech with little merit as though this was a beauty contest. This is as real as it gets. Stocks are cheap and but we are just waiting for a catalyst.

I am long PCU, RIO, PAAS, SCHN, X, GLD and I am short SPY. No, this isn’t a contradiction, I think it will take sometime before positive catalysts finally become apparent, and until then I would rather remain reasonably hedged vs. jumping into this market.

Source: Fed Model Indicates Good Value Exists in Stocks, We Just Need a Catalyst