Using The Fed Valuation Model To Determine Market Direction
As I promised last week,
I will dedicate the next few columns to discussing the current climate of the US
equity markets and what we can expect going forward–in my view anyway. So far,
we have been able to determine that fund flows suggest a neutral bias for
equities, as stock funds have witnessed impressive inflows for the past six
months. But what about other measures, such as valuation?
I though it would therefore be useful to
reexamine the relationship between stocks and bonds in an effort to determine
their relative valuations. The reason why this important is that both of these
instruments compete for the same limited amount of investment dollars.
One of the easiest ways to compare these two
financial instruments is by using the “Fed” Valuation Model, which was first
introduced by the Federal Reserve to the markets in 1997 when Mr. Greenspan
testified before Congress. The model is a very simple one and, admittedly, has
its shortcomings. However, it can be a very useful tool during periods of
disequilibrium between the value of stocks and bonds. For instance, it showed
that stocks were overvalued in August 1987 and in March 2000 (before the stock
market sold off). Conversely, it indicated that the stock market was undervalued
in October of 1998 and again in September 2001 (before the stock market
appreciated significantly).
The underlying assumption made by the model is
that the investment world has two choices when it comes to capital
allocation–stocks and bonds. It therefore compares the yield of the ten year US
Treasury Note with the expected returns of the equity market. The expected
return (yield) of the stock market is calculated by dividing the expected
forward earnings of the S&P 500
(Ten Year Treasury Yield – S&P Earnings Yield) /
S&P Earnings Yield)
Currently, the 10 year note is yielding 4.067%,
the S&P is trading at 1141.55, and the forward earnings value for the S&P is at
61.83. And after plugging the values in the above formula, we get a reading of
-.25, which, according to the model, is telling us that the stock market is 25%
undervalued–for reference, the model was measuring a -23% value at the end of
August when bond yields were significantly higher (4.6%). Most importantly
however, is that forward earnings continue to rise, which still makes stocks
attractive on a relative basis.
For the time being, the Fed Valuation Model
suggests a positive direction for stocks. But as yields begin to rise, the onus
will be on rising earnings, which have sequentially moved higher for the past 11
months, to push the market higher.