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The 'Fed Model' did an excellent job of providing a base line valuation for twenty years. It provided a warning to investors during the "bubble era" of 1999-2000.

Since then, there has been a sustained period where the model has indicated that stocks were undervalued. Some think that the model is "broken." There is another possible interpretation, which deserves our consideration.

We all know that market valuations are not specific timing indicators. I believe that they are better interpreted as long-term sentiment indicators. Instead of viewing the Fed Model as broken, one can look at market history and understand why investor sentiment has been extremely negative for an extended period of time.

This is extremely important since it directly addresses the risk/reward for the 2007 market.

Will this be the year when Misguided Gloom comes to an end?

To answer this question, it is helpful to consider market history over the relevant period. Take a look at the timeline:

factors affecting sentiment and variation from fed model

The red line shows the level of over- and under-valuation of the S&P 500 during the period using the Fed model as our indicator. The range is about 60% over-valued in late 1999, to about 40% under-valued for most of the last few years. Check here for more details.

Y2K - Internet - Technology Bubble

The 1998-2000 time period was truly exceptional, but not in the way investors thought at the time. Market veterans always worry when someone suggests that "this time is different" and so it proved during the Internet/technology bubble.

Economic growth was extremely strong, with real GDP growing in the 4-5% range for several consecutive years. This growth rate was both astounding and unsustainable, but to many, it seemed like a new era of prosperity. In retrospect we can see that part of the growth was artificial. Many businesses, for example, bought new computers rather than worry about how the old ones would deal with the Y2K problem. Internet IPO's flourished for a time, ordering plenty of new equipment and software. Labor markets were stretched thin, with marginal workers drawn into the labor force. This put participation rates at record highs.

The stock market, and especially technology stocks, reached incredible valuations. Individual investors turned to day trading and speculated in IPO's. The savvy professionals who sold stocks short were repeatedly burned and finally gave up. It was a setup for major losses.

The 2001 Recession

The 2001 recession was relatively brief and relatively mild. It was so mild that many did not realize it was happening. It lasted for about eight months, from March, 2001 until November, 2001. Real GDP declined by a fraction of a percent during this period, and actually increased during the calendar year. Market analysts had been looking forward in their estimates. In March, the peak of economic activity, the forward earnings estimates on the S&P 500 were about seven percent lower than four months earlier. By November, forward earnings estimates had declined over seventeen percent from the peak. This time the analysts were wrong, since November actually marked the trough of economic activity.

Future articles will discuss our conclusions more extensively, but an important fact leaps out. Current investors who have not studied the "bubble era" carefully may associate the stock market collapse with the recession. Putting aside the discrepancy in timing, the recession was too mild to create such a major effect. The stock market declined because excessively positive sentiment -- irrational exuberance -- had carried it to levels not justified by the fundamentals.

The Economic Recovery

The economic recovery from the 2001 recession has been the subject of plenty of analysis by Wall Street Researchers. Most of that analysis is very poor. Researchers compare the recovery period with all past recoveries, trying to use a cookie-cutter approach. The cycle pattern is the basis for their forecasts.

This is silly, and it is time someone said so.

The current recovery period has been very different because the time preceding the recession was different -- a lot different. In addition, the economic recovery was inhibited by the 9/11 attacks, the prelude to the Iraq War, a major strike, and a related period of business caution. These all deserve more detailed discussion, including the impact on investor sentiment.

(...to be continued, but I think you can see where this is going. The current market sentiment is stuck in the period of misguided gloom.)

Source: 2007: When Misguided Gloom Comes To An End