Is The Stock Market Really Overvalued?
Not according to the “Fed” Valuation Model it isn’t.
In fact, the model is actually signaling that the equity market is
undervalued at current levels. But before
I continue, let me explain what the “Fed” model is.
The Federal Reserve Stock Valuation Model is a very simple (think Taylor
Rule) ratio that measures the relative value between stocks and bonds
(assuming that investors can only pick one or the other). The tool, as I’ll
call it, compares the yield of the ten year US Treasury Note with the
expected returns of the equity market, or earnings yield.
The expected return
(yield) of the stock market is calculated by dividing the expected forward
earnings of the S&P 500
(
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by the current value of the index. The formula for the Fed Valuation Model Is:
(Ten Year Treasury Yield – S&P Earnings Yield) / S&P Earnings Yield)
Currently, the 10 year note is yielding 3.341%, the S&P is valued at
994.7 and the forward earnings value for the S&P is 56.69. And after
plugging the values in the above formula, we get a reading of -.4138.
Let’s Interpret The Number
If the model treats the yield of the two assets the same, then investors
would surely choose the higher yielding asset right? As such, since the stock
market’s current yield is considerably higher risk (now at 5.7%), then investors
should be buying stocks. Moreover, the current negative .4138
reading on the Fed Model is telling us the the ratio between the two assets is
almost 2 to 1–in favor of Treasuries, and that equity investors are being
over-compensated for their investment relative to Treasuries.
How Accurate Is the Fed Valuation Model?
It showed an overvalued reading in August 1987 (+.34) and in March 2000
(+.52) . Conversely, it indicated that the stock market was undervalued in
October of 1998 (-.10) and again in September 2001 (-.11).
So I’ll let the readers of this column decide for themselves.
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