Is The Fed Model Flawed?

by: Jeff Miller

How did the Fed Model do in 1981? Commenting on our site here, Barry Ritholtz states:

...according to the Fed Model, in 1981 stocks with depressed earnings and sky high interest rates were crazy expensive -- just as the greatest bull market in US history began.

That is a VERY significant flaw in the Fed Model. Missing what may very well be the greatest buying opportunity in a generation raises some very serious questions about any model that proclaims to be able to determine valuation.

Listed below are the monthly data we have for the time in question:

fed model

While the comparison shows the market as slightly overvalued in April and May of 1981, and again in August of 1981, those are the only such months. We have repeatedly said that the Fed Model is not a short-term timing method, but it actually would have worked in 1981. An investor selling in the cited months would have had ample opportunity to enter the market at better prices.

There is nothing to suggest that an investor would have missed out on a major move. We covered the history of valuation deviations in a previous article, including the chart below.


As we noted in our review, many researchers do not actually use forward earnings. They attempt to "simulate" expected earnings through some arithmetic method. We wonder if Barry is using data from such a source. Perhaps he will enlighten us with an actual data series or chart illustrating his point.