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Paulo Santos, Think Finance (374 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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From time to time, you get news claiming the Fed Model shows stocks are cheap. Rarely do they say the market is expensive, and it would be even rarer that you’d hear about it then. Unfortunately, the Fed Model is usually wheeled out when stocks are not far from some kind of medium-term top, and arguments need to be found to attract people to the market.

It is well known that the Fed Model has issues, and it isn’t hard to find both recent, and rather old, articles talking about them.

Still, now that the market has undergone a significant correction that is mostly happening in lockstep with a concomitant fall in interest rates, it might be useful to check how that model is looking, compared to its long term history.

For this, we will use Robert Shiller’s earnings data, together with the most up-to-date estimates compiled by S&P (I used S&P’s implied earnings growth from 2010 to 2011 to complete Shiller’s data for the last 5 months).

The chart below is the result:

What we can see is that the Fed model spent most of its history calling for a steep rise in stock prices, including even before such disasters as the 1929 crash. It is only since 1959 or so that some kind of close relationship between the S&P and its Fed model implied value emerges, and then the model spends much of the eighties and nineties calling for overvaluation. Much of this is already present in the critiques linked above.

However, today’s departure from the Fed model really appears to be significant, although much higher departures were recorded in the distant past. It must be said that those significant peaks in the past were also followed by significant rallies, even if the peaks could be much higher than what we are witnessing now.

So, at the very least, the Fed model can presently serve as a signal that maybe it is the right time to look for alternatives to buying 10 year bonds at a 1.97% yield, especially when even the S&P500 already yields above 2%. Although a large market rally is not a certainty, the mere possibility that it could happen from the present levels needs to be included in our minds and investment strategies.

Yes, Europe is relevant because of its potential economic and market impact, but Asia is no less important and it might well provide a cushion to any market impact, as already can be seen in the earnings of companies like Intel (INTC) (57% of last quarter's revenues came from Asia vs only 13% from Europe, though the final users should be more in-line).

Also, when we look at the interest rates and how long the S&P peak has been, Japan comes to mind. Japan had its stock market peak in 1990, 21 years go. If we were to draw a parallel, we could easily come to the conclusion that the US market “has gone Japanese” and has a long slog ahead going nowhere. This, however, misses two important factors: valuation (Japan started from a bubble base, the US presently is clearly not in one) and demographics (Japan is experiencing decreasing population, the US is still growing).

Conclusion

There are many other factors and threats, the Fed model has many flaws, but the divergence being witnessed today between the Fed model and the market, together with the very low interest rates and non-demanding S&P valuation (both in terms of PE – 13.0 - and dividend yield – 2.20%) lead us to think that it is not impossible to see a significant market rally from the present levels.

Source: What Is The Fed Model Saying Now?