Why the “Fed Model” Doesn’t Work

In this weekend’s Barron’s, Mike Santoli has a very simple criticism of the (so called) Fed Model for determining if equities are cheap or expensive (The Flaws in the Fed Model).

Stated simply, the “fabled stock-market predictor doesn’t work.”

The idea here, once formalized as the “Fed Model,” is that stocks’ “earnings yield” (reported or forecast operating earnings for the S&P 500, divided by the index level) should tend to track the Treasury yield in some fashion. With this earnings yield now above 7%, based on a trailing price-to-earnings ratio near 13, this model and its various offshoots render equities a no-brainer buy. Or, if one prefers, that Treasuries are in a reason-defying bubble.

This simply doesn’t hold up in theory or practice. The Fed Model only “worked” as a predictor of market action in the 1980s and ’90s, when bond yields were steadily descending and stock values consistently rising as inflation and interest rates were slowly strangled. Both before that period and since, the Fed Model relationship has been mostly a non sequitur in terms of foretelling market performance.

For sure, the Fed Model is useless. But why it is useless is not well understood by most investors. Understanding this about the Fed Model or any other Wall Street hokum may help you look askance at other seemingly plausible, even persuasive arguments that actually fail.

Regarding the the Fed Model, it does not do what it claims to do. It does not tell an investor if stocks are cheap. Back in 2008, I made an attempt at explaining why: The key taker away is that it controls for two variables — not just one:

Note that the formula contains two variables: While it is commonly described as a way to evaluate when stocks are over- or under-valued, the other variable in the formula above is the forward S&P500 earnings consensus. SPX prices and the 10 year yield are the knowns, while BOTH valuation and forward earnings estimates are the unknowns.

Thus, the Fed model today might be telling you either of two things: When equities are undervalued — or when consensus earning estimates are simply too high.

–The Flawed Fed Valuation Model, February 5, 2008

Said differently, the Fed model assumes analysts consensus is accurate. That assumption has been the undoing of many an investor . . .

Source:
The Flaws in the Fed Model
MICHAEL SANTOLI
Barro’s, June 9, 2012
http://online.barrons.com/article/SB50001424053111904470204577446371761637272.html