O tempora, o mores! How times have changed. In the roaring 90s, the talismanic metric for analyzing the stock market was the Fed model. Under the Fed model, the ratio between stock prices and forward earnings was targeted at the inverse of the interest rate on the 10-year Treasury. Thus, if the 10-year Treasury interest rate is 5%, the P/E ratio should be 20-to-1. Simple, easy to calculate, and very useful in explaining the high stock prices we all enjoyed in that era.
Alas, the metric appears to be useless in today's market. If literally applied, the Fed Model would imply a P/E of more than 50-to-1 and an S&P 500 nearing $5,000. Something has gone terribly wrong. It may be useful to analyze exactly why the metric may be relevant in determining to what extent it still has validity. In doing so, we may be able to determine what parts of the market are mispriced.
1. Fundamental Considerations
I generally try to buy equities that are priced substantially below the private market value. This is the price that a buyer would pay to acquire the entire company under normal circumstances. In a transaction financed partly through debt, the interest rate on the debt reduces the cash flow available to the new owner. A lower interest rate on the debt increases the cash flow available to the equity holder and, all things being equal, should increase the value of the new equity, in turn increasing the price the equity holder is willing to pay for the company. Another way to look at this is that the weighted average cost of capital is decreased due to the lower interest rate on the debt component. Notice that what is relevant here is the interest rate obtainable in a takeover transaction and not the interest rate on 10-year Treasuries. Notice too that the result depends upon "all things being equal." There are clearly limits to the efficacy of this transmission mechanism to turn lower interest rates into higher equity prices.
2. Competing Assets
Investors constantly have to determine the comparative merits of stocks, bonds and cash in their portfolios. Of course, lower interest rates reduce the yield on bonds and ultimately create some risk in bond portfolios due to price erosion in the event interest rates increase. Arguably, at least, this may lead investors to turn to equities and buy stock until the "earnings yield" on stocks equals the yield on bonds. There are several problems with this analysis. First of all, the earnings yield on stocks is not delivered to the investors in the form of cash -- only the dividends are so delivered. Second, all sorts of corporate bonds and other financial instruments are available that yield much more than 10-year Treasuries. Finally, the "earnings yield" on stocks is much more uncertain than bond yields and must command a risk premium.
Still, there likely comes a point that dividends from reliable dividend payers become very attractive in comparison with bond yields (completely setting aside the favorable tax treatment afforded to dividends). Thus, if the Fed model still has relevance, we would expect a market rally to be led by equities like real estate investment trusts, master limited partnerships, utilities, telephone companies, business development companies, and other companies paying relatively high and relatively reliable dividends. In fact, this appears to be the case, although there are some laggards that are worthy of attention.
3. Financial Engineering
Another transmission mechanism that can result in low interest rates producing higher stock prices is financial engineering. This can take several forms. In the simplest case, a corporation can simply refinance its debt at a lower interest rate and thereby reduce its interest expense and increase its earnings. Coca-Cola (NYSE:KO) appears to have done this successfully. It is probably not a very important factor today because of low debt levels of most industrial companies but it is certainly a positive factor. Another form that financial engineering can take is a debt financed share repurchase -- essentially replacing equity on the balance sheet with debt or engaging in "capital structure substitution." As long as the company's stock is trading at a P/E less than the inverse of the after tax cost of the debt, this transaction will have the effect of increasing earnings per share. Thus, if a company borrows at 6 % and has a 35% tax rate, its after tax interest expense is less than 4% and it will increase per share earnings as long as it buys its own stock for a price less than 25 times earnings.
It is not surprising that each quarter we seem to set a new record for share repurchases; it also may explain why earnings "per share" keep increasing even though total revenue is sluggish. Finally, a company can increase its earnings per share by engaging in a cash for stock acquisition as long as it pays a multiple of earnings less than the inverse of the after tax cost of debt used to finance the transaction. It is somewhat surprising that we have not seen more acquisitions in this interest rate environment.
The Fed model should not be used mechanically to anticipate the direction of stock market averages. On the other hand, an analysis of the mechanisms by which interest rates can affect equity valuations may be useful in identifying particular equities that are strikingly cheap in comparison with bonds or are well-positioned to benefit from financial engineering. For a long time, I bought Wal-Mart (NYSE:WMT) whenever it dropped below $50 a share, reasoning that its ability to obtain cheap financing was driving an aggressive share repurchase program that would ultimately reduce share count from 4 billion to 3 billion shares.
I think that the above considerations make Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO) particularly attractive here because their large cash positions assure equity holders that dividends will likely continue to be increased and shares can be repurchased on attractive terms. I think that Proctor & Gamble (NYSE:PG) is very attractive at the current price level in comparison with any available fixed income alternative. I have no idea where the averages are headed, but it is striking that a metric so recently embraced by the industry suggests much, much higher valuations. As I have indicated before, for the long-term investor there is a certain degree of risk associated with being out of the market.