Time-Tested Signs of an Overvalued Market

The problem with the so-called Fed model — which compares the yield on the 10 year with the dividend yield on the S&P500 — is that it effectively counts low interest rates twice.

When interest rates are low, companies borrow at very favorable rates. The cost of capital is less, and that helps their bottom line, making them more profitible — in effect, raising the “E” part of the P/E equation. Of course, dividends are paid out of profits.

When rates are low, the S&P500 dividend yield look relatively high. In that instance, the Fed model suggests that, (relative to the 10 year yield), stocks are undervalued.

Thus, low interest rates in this formula get incidentally counted twice. This makes stocks look cheaper — when compared to 10 year yields — by relying in large part on earnings driven by low borrowing costs, interest rates are “double counted.”

This conceptual flaw should hardly be the underpinning for a rigorous model. Now, Mark Hulbert reports of an academic study which demonstrates the problems of the Fed Model:

A RECENT academic study seriously undermines a popular reason for not worrying about the high price-to-earnings ratio of the stock market today: the idea that the ratios should be high when interest rates are low.

The theoretical basis for this claim is the so-called Fed Model, which compares the interest rate on the government’s 10-year Treasury note with the inverse of the stock market’s P/E ratio – known as the market’s earnings yield. The stock market is considered undervalued when its earnings yield is greater than the Treasury note rate.

According to this model, the stock market is significantly undervalued right now. The P/E ratio of the Standard & Poor’s 500-stock index is now 18.2, based on companies’ estimated operating earnings for 2004. That translates into an earnings yield of 5.5 percent, much higher than the current yield of 4.09 percent for the 10-year Treasury note.

If the Fed Model held true, earnings growth should be slower when Treasury note rates are high and faster when those rates are low. Historically, however, that has not been the case, according to the new study, “Inflation Illusion and Stock Prices,” by the Harvard finance professors John Y. Campbell and Tuomo Vuolteenaho.

Note that the Fed Model is not endorsed by the Federal Reserve. It was constructed by Dr. Edward Yardeni, (chief strategist at Prudential Equity, who maintains this excellent page: Dr. Ed Yardeni’s Economics Network). Yardeni supposedly based it on comments in the Fed’s Monetary Policy Report to Congress in July 1997.

Source:
STRATEGIES: A Time-Tested Sign of an Overvalued Market
By Mark Hulbert
NY Times, February 22, 2004

http://www.nytimes.com/2004/02/22/business/yourmoney/22stra.html

Inflation Illusion and Stock Prices
National Bureau of Economic Research working paper
Professors John Y. Campbell and Tuomo Vuolteenaho, Harvard University

http://www.nber.org/papers/w10263

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