There’s a little-known valuation theory called the Fed model.It’s little-known because it has so many critics.
Basically, it looks at the earnings yield of a stock, which is earnings/price ratio, and compares it to the yield on a long-term Treasury security. The idea is that these two ratios somehow track each other.
It was reportedly dubbed the Fed model by Ed Yardeni, who was referring to an instance when Federal Reserve Chairman Alan Greenspan compared the two ratios during a testimony/speech.
Anyways, the Fed model would suggest that stocks look incredibly cheap right now versus Treasuries.
But Barron’s columnist Michael Santoli argues that the model is bunk. From this week’s print edition:
Much of the Treasuries-versus-stocks talk conjures an imaginary comparison shopper, compelled always to buy something and evaluating these two lone choices on equivalent terms. Yet between Treasuries—the ultimate safety and liquidity play—and equities resides just about the entire spectrum of available asset classes to choose among. If Treasury yields driven lower in a flight from risk somehow improve the attractiveness of stocks, they also do so for corporate debt, munis, real estate, diamonds, McDonald’s franchises, and all the rest.
Then there are the facts that the Federal Reserve’s zero short-term rate policy is forcibly anchoring Treasury yields, that the U.S. isn’t even among the bottom six in terms of government issuers in terms of low yields, and that institutional Treasury buyers are mostly seeking liquidity and security—not great value or juicy returns—in a world where low-risk assets are scarce.
Another vocal critic of the model is Barry Ritholtz of Fusion IQ and The Big Picture blog. “For sure, the Fed model is useless,” he writes.
Ritholtz refers back to a 2008 comment he wrote nailing one key criticism of the model.
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.
It sounds like it’s time to put the Fed model to sleep.
Read more from Santoli at Barrons.com.
Read more from Ritholz at Ritholtz.com.
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