Dow 47,150: Rethinking The Fed Model

Includes: AAPL, JNJ, MSFT, T, WMT
by: Philip Mause

Back in the 1990s (boy, does that thought make me nostalgic!), a noted financial pundit came up with the "Fed Model" - which involved an attempt to value the stock market based on prevailing interest rates. The model went through various iterations but, in its most basic form, it assumed that the earnings yield on stocks would be equivalent to the interest rate on 10 year Treasuries. The earnings yield is the inverse of the price earnings ratio and so we can easily make this calculation today. This weekend the interest rate on 10 year Treasuries was 1.94%; to get an earnings yield of 1.94%, the Dow would have to have a PE of 51. Using Barron's trailing Dow earnings of 924.53, this produces a Dow valued at 47,150.

There were a number of other versions of the Fed Model - some of them used after tax interest proceeds from Treasuries (and would therefore produce higher PEs), others used future year earnings and some used after tax interest on intermediate bonds. Bear Stearns (remember them?) had a version which used projected inflation and interest rate spreads. The most pessimistic version would be pre-tax interest on intermediate bonds compared with trailing earnings. Even this version produces a much higher Dow. Barron's bond index indicates an intermediate bond interest rate of 6.56% - this would suggest a PE of 15.2, well above the 13.37 at Friday's closing. On the other hand, the most optimistic version would price the Dow at roughly 70 times projected earnings or in the 70,000 ionosphere.

Because the stock market, in the short term, is a "voting" rather than a weighing mechanism, we cannot really rely on any of these metrics to give us guidance on day to day market activity. And it is very true that, prior to 1980, there were periods of time when dividend yields on stocks were higher than interest rates on ten year Treasuries (as they are now). So I am not predicting that the Dow will reach 47,150 in my lifetime (I am 67, overweight, and have had heart surgery - on the other hand, my father smoked two packs a day and lived into his 80s). That said, I nevertheless believe these ratios do tell us something about what to expect going forward.

We are likely to continue to have an interest rate impacted stock market. What does this mean? For one thing, it is not an accident that utilities were the best performing group in 2011. Utility stocks benefit from lower interest rates in a number of ways. They have a lot of debt which can be rolled over at lower interest rates. Because they are reliable dividend payers, they are also ready alternatives for fixed income investors impatient with low bond yields. As a group, they have consistently, although very slowly, increased dividends - even through the 2008-09 Panic.

We will also likely see a continuation of intensive share repurchase activity. As I have pointed out in other articles, a company can increase per share earnings by buying back stock with balance sheet cash or funds borrowed at low interest rates. Share repurchase activity has reached record levels. We should bear in mind that comparisons with time periods prior to 1980 may be distorted by the fact that the SEC issued its Safe Harbor share repurchase rules in the early 1980s and so the share repurchase mechanism may not have played as important a role in markets prior to that time. I think that the market is finally beginning to price in the fact that Wal-Mart (NYSE:WMT) is in a multi-year effort to substantially reduce its share count; the same is true for Microsoft (NASDAQ:MSFT), although the market has been much slower to price it in.

If spreads begin to decline (for example if one year LIBOR goes back to the levels of one year ago), I think we will see intensive LBO activity and cash for stock acquisitions. At the present time, certain companies are in the position in which the opportunity cost of cash is very low. These are the companies with large amounts of balance sheet cash - most notably, Apple (NASDAQ:AAPL) - and the companies whose bond rating gives them access to very cheap borrowing - including Microsoft (MSFT), Wal-Mart (WMT), Johnson & Johnson (NYSE:JNJ), and AT&T (NYSE:T). A reduction in spreads would have the effect of increasing dramatically the number of companies for whom borrowing is dirt cheap. This would likely increase the level of LBO and cash for stock takeover activity.

Reliable dividend paying stocks will continue to do well and, in the absence of a panic or specific problems with a company, there will be strong market support for stocks as the yield approaches 4%. This means that many companies may begin to settle in at yields in the 2.5-3.5% range; it also means that every time the dividend is increased, the stock price will tend to trade up to keep the yield in the same range. A stock that yields 3% and increases its dividend 10% a year will tend to produce an overall return of 13% - which is not bad in a world with almost no inflation.

All of these trends will be quickly and overwhelmingly swamped by panics, squalls and other events producing tumultuous sell-offs from time to time but, in the absence of an actual financial meltdown, these trends will be important factors in defining market direction. The Fed Model is probably dead as a reliable predictive tool of how the market as a whole will be priced but it still tells us a great deal about the nature and dynamics of the forces underlying the market and may help us identify areas of strength.

Disclosure: I am long MSFT, WMT, T, JNJ, AAPL.

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