The Fed Model and Scaling the Wall of Worry

by: Jeff Miller

There are two interesting themes in current market commentary. There is a connection that is not recognized by either group. Let us introduce the writers to each other.

Critics of the Fed Model - the First Group

At "A Dash" we have discussed criticisms of the Fed Model, a simple tool that can give the individual investor a feel for the important asset allocation decision.

Many critics test the Fed Model for market timing. Here is one recent example. The CXO Advisory blog also has a good summary of research taking this approach.

We believe that this is the wrong way to use the model. It is better viewed as a gauge of long-term sentiment. In the bubble era, the model correctly signaled that stocks were overvalued. When interest rates hit bottom, the model showed stocks to be vastly undervalued.

The market did not agree because there was a palpable fear of global deflation. To take the argument to an extreme, would one pay a 50 P/E multiple for the S&P 500 if interest rates were 2%? The fear of a recession undermined expectations about forward earnings. Those fears proved to be unfounded, but the concern was a real one. The Fed Model showed the sentiment of the time.

Bearish Market Pundits -- the Second Group

There is widespread coverage of various threats to stock prices from the usual suspects, frequently cited on "A Dash." The issues involve include topics like the following:

  • Housing price declines and an inventory of homes for sale.
  • Continuing predictions of "mean reversion" in corporate profits.
  • The collapse of consumer spending.
  • High energy prices.
  • A "boxed-in" Fed raising interest rates.
  • Terrorist threats.
  • Middle East geopolitical concerns.
  • The Democrats winning the 2008 elections.
  • And now - hedge fund blowups like the Bear Stearns case.
  • We may have missed a few, but the idea is clear. To those writing on these topics, the market has rallied to new highs in the face of these important fundamental factors. The pundit conclusion is that everyone buying stocks has foolishly ignored the signs that only they can see.

    Bringing the Groups Together

    An experienced market observer might wonder how so many could have missed the list of concerns. All of the items on the list get frequent attention in the press, on television, and in many blogs. This is not fresh information.

    A more plausible explanation is that the market trades at a significant discount to the normal "fair value" for the very reason that investors are very worried about the list of worries. The Fed Model, currently showing a discount of about 25% on the S&P 500, is a good reflection of the market sentiment.

    The bearish pundits focus on worries rather than quantification. In fact, U.S. stocks have never caught up to the multi-year, double-digit expansion in profits.

    Private Equity

    Private equity funds have actively exploited the loose arbitrage between low interest rates and high forward earnings expectations from stocks. The resources for these funds are growing as many institutions seek alternative investments.

    We will write more on this topic, describing our conclusion that private equity actions are based upon fundamental valuation rather than a "bubble" phenomenon. We can only do so much in each post.

    There may also be a quiet period in this activity as participants all go on vacation in August. Some will, no doubt, seize upon this as proof of a "bubble."


    U.S. stocks currently trade at a significant discount because of the long list of worries. These concerns do not represent fresh information. Most of the arguments raised have been out there for years. Here is the real contrarian position:

  • The Fed continues to steer a wise course toward modest growth and low inflation expectations. No one seems to believe this, even though predictions of failure by the Fed were the most costly investment research of 2006 for those who believed it.
  • Corporate profits continue to grow. Many are also skeptical about this.
  • The consumer, supported by strong employment, continues to buy. Many are buying the "spent up consumer" hypothesis.
  • Corporations increase investment. This is another surprise.
  • It is a classic case of scaling a wall of worry, the classic pattern for market strength. We will see the top in the market when there is massive short-covering, piling in by individual investors, and finally, investment in US equities by foreigners. We are not even close to these signals. For the best discussion of these issues, by someone who has been absolutely right for several years, check out the commentary at Between the Hedges. Take some time to look back at the archives to appreciate the accuracy of the forecasts.

    That is why we expect stocks to move much higher this year.