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The Fed Model provides a quantitative analysis of the basic investor decision: Buy stocks or buy bonds?

The following chart compares the S&P 500 to "fair value" as determined by the Fed Model, ending in 1998. It is presented on a log scale to facilitate comparisons over a long historical period.

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fed_model_thru_98

One can see the basic quality of the overall fit, but there are other important observations. In the Crash of '87, for example, one would not have wanted the model to track the S&P in the days preceding the crash. A valuation model should not be expected to trace the market exactly, but rather provide a warning of anomalies. The period around the first Gulf War provides a similar illustration.

One might ask why our analysis begins where it does. The reason is that we do not have a record of forward earnings before 1979. Anyone reading a Fed Model study that purports to go farther back in history should carefully read the footnotes to see if forward earnings are really being used.

If we had more data, what would or should we use? We'll take up this question in our overall review, but regular readers of "A Dash" know that we are extremely skeptical of very old data. Many big-name investment research firms use data going back to the Great Depression. One Fed Model critic found trailing earnings for a test going back to 1871, although we cannot imagine why! A good dividing line might be the invention of market derivatives like stock options and futures and the development of computer-based econometric models.

Let us now take a look at the Fed model including the next period, the Internet/Technology/Stock Market Bubble. This is a period that is now generally recognized as one that involved excessive stock valuations. Here is what the model shows:

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fed_model_thru_01

A prescriptive model should offer advice; the advice here is similar to the acclaimed work of Robert Shiller. It shows excessive valuations beginning in 1997 (was it time to sell?) and the big valuation gap at the bubble peak. Since we believe that is what actually happened, the model is also a good descriptive model. It accurately identified irrational exuberance and excessive stock valuation. Despite this performance, some critics alleged that the Fed Model "did not work" because it did not track actual market levels. One wonders whether these critics just write articles or actually invest. Most of us would be delighted to have wise counsel that investment in stocks was dangerous.

Anyone who is intrigued by the Fed Model performance from 1979 to 2001, and you should be, might wish to study the current chart.

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fed_model_to_date

The key feature of the current chart is the persistent valuation gap. Stocks became under-valued in 2002 and have remained so for about four years. It may be helpful to consider "fair value" as a horizontal axis to emphasize the deviations. Here is a look at the same data using that approach. This view enables us to focus on the deviations over time.

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sp_over_fv

According to the model, we are in the longest sustained period of deviation from calculated fair value in the entire time period. This intriguing situation deserves further investigation.

Since interest rates and stock prices are known, the only remaining variable in the model is projected earnings. One could conjecture that the forward estimates are incorrect. Or one could argue that "things are different this time" and that the relationship between stocks and bonds no longer holds. Or one could argue that the model is leaving out important considerations that have had a special relevance in the last four years.

The next segment of this series will offer our analysis of this valuation gap. We will then turn to criticisms of the Fed Model. In the last of this series of short articles we will ask what stocks might be of special interest in the coming year.

Source: Using The Fed Model To Understand This Market