Review: The Fed Model’s Flawed Valuation
A year ago (Feb ‘08), I tried to explain why the (so called) Fed Model was worthless as a measure of valuation:
“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 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.”
Surprisingly, there was lots of pushback on that. I didn’t get why (other than people talking their books). This is not complex — its a basic analysis of knowns versus variables in a simple formula. What the forward earnings will be is an opinions, not a fact.
Plug and chug led to this conclusion:
So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half.
Anyway, think back as to which analysts/fund managers/talking heads who used the Fed Model as their justification for claiming equities were cheap 1 or 2 years ago and buying them; put them on your DO NOT CALL/IGNORE list. They are clueless dolts who will lose you money if you listen to them . . .
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Previously:
The Flawed Fed Valuation Model (February 2008)
http://www.ritholtz.com/blog/2008/02/the-flawed-fed-valuation-model/
Cheapest Stocks in Two Decades based on Flawed Fed Model (April 2007)
http://www.ritholtz.com/blog/2007/04/cheapest-stocks-in-two-decades-based-on-flawed-fed-model/
Time-Tested Signs of an Overvalued Market (March 2004)
http://www.ritholtz.com/blog/2004/03/time-tested-signs-of-an-overvalued-market/
March 8th, 2009 at 6:50 am
It seems that stocks are always undervalued. When the market is growing, the clueless dolts always use their wildly exuberant forward earnings estimates to calculate the P/E ratio and make it look LOW.
But when stocks are declining, as now, those same clueless dolts switch to the trailing earnings.
Case in point, is this from MSN Money’s Market Report: Stock Ticker:
“13:30 ET……..
“…….The steep losses have pushed the stock market to new multiyear lows. At its current level, the S&P 500 trades at a price-to-trailing earnings ratio of 10.0. In 2008, the market’s P/E averaged 15.6. …….”
In today’s market, I guess what I really want to know is what the P/E is using a “reasonable” forward estimate.
March 8th, 2009 at 7:51 am
During the last bubble, when presented with poor past data on the economy these salesmen would retort, “Those are backward looking indicators…”
Now, they take their sophistry a step further even claim that that some “indicators” are lagging indicators (e.g. ‘The unemployment rate of Baltic Dry shipmates is a lagging indicator.” ) Maybe they were, but nobody knows if they will be.
March 8th, 2009 at 9:43 am
For those interested in a more detailed profo that the Fed Model is worthless, Hussman did a great piece on it a year and a half ago…the model is a hoax…a statistical artifact that happened to look right for a short period (1980-1998)…outside that timeframe, it has been useless.
http://www.hussmanfunds.com/wmc/wmc070820.htm
March 8th, 2009 at 9:48 am
from the Hussman piece:
“You’ll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990’s bubble, the forward operating P/E for the S&P 500 averaged just 8. That’s not a typo.”
This is why I believe, despite where rates are, the forward P/E in this crisis must go to 8 and likely lower…about 450 on the S&P, unless earnings tank even more.
March 8th, 2009 at 11:01 am
It is beyond hilarious that the free market ideologues that populate wall street, and dominate the economic discussions of nation expect us to simultaneously believe that ‘the market knows all’ and that ‘assets are undervalued by the market’. The charitable interpretation is that they are guilty of the all to common failing of having confused ideas, whose purpose is to support their self image: ’stocks = good, stock market games = good’ therefore ‘whatever it takes to hold that belief, I will hold’. The uncharitable version is that there is a deeply deceptive con game going whose purpose is to concentrate wealth in the hands of those smart enough to understand the con, and lucky enough to be in the right place at the right time. On the other hand, since all cons begin with conning oneself, these two interpretations are actually the same. And since different people have different reasons for what they do, they are also both true.
It was Thorstein Veblen, an economist we hear all to little about, who recognized that economics has an essentially psychological component. His phrase was ‘invidious comparison’. The idea is that a majority of people will support a system that only a few prosper under, hoping that they will be among the lucky few.
March 8th, 2009 at 1:45 pm
Does anyone have access to 401-k data? I think it would be very informative to know what people are doing with their 401-k investments. In other words, have they bailed out of stock funds yet? I’m guessing not, but who knows.
Shouldn’t this data be available somewhere? Either from employers or whoever runs the employer 401-k plans? Seems like it would be very easy to track the investment changes at one large company and get a good idea of what employees are doing throughout the country.
Re: the Fed Model…i think Jim Stack has put the dagger in that theory more than a few times.
March 8th, 2009 at 2:23 pm
@Clem:
This article has a lot of info for you…from LA Times:
http://latimesblogs.latimes.com/money_co/2009/01/401k-wall-stree.html
Highlights:
Boston-based Fidelity, the administrator for 401(k) plans covering more than 11 million workers at 17,100 companies, said the average plan balance tumbled to $50,200 last year from $69,200 in 2007.
The totals include contributions workers made during the year. So actual investment losses were worse than the 27% drop in the average balance. The average U.S. stock mutual fund slid 36% for the year; the average foreign stock fund plunged 44%.
Still, most people continued to add to their accounts in the fourth quarter, even as markets dived, Fidelity said.
Fidelity’s survey also found that just 6.1% of plan participants made exchanges among investment options in the fourth quarter, suggesting that there was no rush out of stock funds and into safer options.
March 8th, 2009 at 3:02 pm
Clem,
try this, as well: http://www.ici.org/stats/mf/index.html#TopOfPage
ICI is the industry organ..
http://www.ici.org/
March 8th, 2009 at 3:08 pm
http://www.ici.org/stats/mf/retmrkt_update.pdf
3Q ‘008 update on ‘retirement fund’ biz, incl. 401(k)
from an academic research POV: http://w4.stern.nyu.edu/salomon/docs/assetmanagement/asset_management_abstracts.htm
March 8th, 2009 at 3:52 pm
When yesterday’s numbers suggest stocks need to go down to match past major recessions, and forward looking numbers are going down as we write — well, I’m not confused.
March 8th, 2009 at 7:39 pm
I always felt the Fed Model was one of the dumbest pieces of crap ever foisted on the investment public.
Back in 2004-2005, I used to say, “Well, if interest rates go to 1%, should we just put a 100 PE on the market then? Because we will be in the Great Depression part two.”
I was being facetious at the time–little did I know….
BTW, Clifford Asness at AQR Capital also did some very good work on the stupidity of the Fed Model thesis.
March 8th, 2009 at 8:18 pm
The only valuation model I trust is John Hussman’s Prior Peak Earnings Model (PPEM). PPEM now has the SPX at a multiple of 8.05 X PPEM. This is close to the market’s trough valuation during the 1970s bear market, but nowhere near the trough valuation of the 1930s bear market.
The PPEM calculates the SPX P/E by dividing the SPX price by Prior
Peak Earnings, a method developed by John Hussman, manager of the Hussman
Funds. (hussmanfunds.com) It orients valuations to the long-term
rising trend of earnings growth as defined by peak-to-peak earnings.
March 8th, 2009 at 9:28 pm
Steve & Mark,
Thanks for those retirement info links. The one sentence that said the most to me was, “Fidelity’s survey also found that just 6.1% of plan participants made exchanges among investment options in the fourth quarter [of 2008].”
The available data is too old. Ideally, it would be nice to track daily changes in real time. I imagine Fidelity does exactly that, but i doubt they freely cough up the information.
March 8th, 2009 at 11:15 pm
Clem,
these cats may get a little closer, though they don’t get to 401(k)-level granularity..
http://www.trimtabs.com/research_description.html
and, re: Fidelity, I’d imagine the same, if they were paying attention, they’d monetize that info stream by offering subscriptions to that data, not to say that they aren’t..
March 12th, 2009 at 2:01 pm
The Fed Model is misspecified. I derived a different version of it starting with the Dividend Discount Model.
http://alephblog.com/2007/07/09/the-fed-model/
For what it is worth, the model said switch from stocks to corporate bonds in August 2008. It still says bonds are better now.