Today, we dissect the battle between the believers and the infidels (better known as Bulls vs Bears), and the schools of thoughts underlying each side’s perspectives.
The Bulls point to the so-called Fed model; It compares the earnings yield of the S&P500 with that of 10-year Treasuries. There should be a rough parity between the two, goes the theory; When the earnings yield is appreciably lower on the 10 year than the S&P500, it reflects an undervalued stock market – prompting comparison shoppers to choose between stocks and bonds. Based upon this model, the S&P500 is ~30% undervalued. That suggests a move to SPX 1500, and Nasdaq 2000.
Several researchers have found flaws in the Model. Ned Davis Research observed that the Model worked well from 1980 to 2000, but was not reliable before 1980. Others note the model fails to incorporate risk (Treasuries being guaranteed by the USA) and does not account for inflation.
On the flip side are historical measures, which suggest the Markets remain pricey. Long term measures of P/E, Price to Book, and Dividend Yield disagree with the Fed Model’s conclusions. The markets have always “returned to trend” near a P/E of 14; Assets well above trend do not reward investors over the long haul, whereas those below do, reversion to the mean (RTM) advocates argue.
RTM is why all hitting streaks end, why the hot hand grows cold, why the house eventually wins. The mathematical issues of RTM can be resolved in one of 3 ways: 1) If it “really is different” this time; 2) If earnings increase dramatically (raising the “E” lowers P/E); or 3) Stock Prices come down a lot (a lower “P” also lowers P/E).
This battle between the Fed model advocates and the Reversion to Mean theorists will determine where the market goes. Fed model folks are in ascension; The reversion to the mean crowd will eventually assert themselves. Meanwhile, Sentiment governs the day to day.
One final thought: Interest rate increases not only make companies less profitable – its more expensive to borrow money – it also makes stocks appear less of a bargain as vis-a-vis the 10 year as yield rises. It’s a double whammy for stocks if the Fed raises rates –lowering profits and hurting valuations. If the economy manages to improve only modestly, the Fed might still be loathe to raise rates a year from now . . . Its quite possible that we may not see rate increases until after the 2004 Presidential elections.
FT: US ‘faces future of chronic deficits’
CNN/Money: Is the fed model broken?
Grantham: The Trend is Your Friend
The Economist State Budgets Disasters: Head ignores the Feet http://www.economist.com/printedition/displayStory.cfm?Story_ID=1800814
NYT: Allies to Retain Larger Iraq Force as Strife Persists http://www.nytimes.com/2003/05/29/international/worldspecial/29IRAQ.html
Morgan Stanley: Profit Myths
Washington Post: Disappearing Democrats
Quote: “Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius-and a lot of courage-to move in the opposite direction.”