Friday, May 20, 2016

Fed valuation model is dead and the Fed killed it

A financial model can be dead, but the users may not know it. It can be a zombie model that is out in the environment, was formerly productive, but serves no useful current purpose. This description can apply to the Fed model for equity valuation.

So why did the Fed valuation model become a zombie? - The Fed killed it. 

The model is based on the assumption that there should be a relationship between the earnings yield and interest rates for long-term bonds. Both discount future cash flows. Investors should be indifferent between between these yields. If the earnings yield, (inverse of P/E), is high (low) relative to bonds, investors should buy (sell) stocks and sell (buy) bonds. Of course, this is a relative model which tells use the richness and cheapness of both bonds and stocks. If one is rich, the other is cheap.  It suggests that one may do better or worse than the other and not whether one market will have an absolute gain or loss. Unfortunately the Fed model has failed for some time.

The chart shows the 10-year Treasury yield and the 12-month forward earnings to price. The deviation between Treasury yields and earnings yield diverted years ago and has continued that way without much change. There are strong arguments that the model is poor by construction. A Treasury yield is a nominal rate while earnings will adjust to inflation. Investors should understand this difference; nevertheless, it is still followed by many.

There is no doubt that inflation has been low for most of this period. Additionally, there has been a downward trend in real rates of interest based on a number of solid reasons which can be a cause for the divergence.  Of course, determining the equilibrium rate of interest is even more difficult when rates are close to the zero bound. But, a key reason may be the manipulation of interest rates by the Fed. A manipulated rate should not be used as an anchor for relative value. Following the Fed model would have been financially dangerous.

Nevertheless, the relationship between stock dividends and 10-year yields has persisted up until this year. There is a link with the the actual pay-out of cash to investors and Treasuries but not the earnings yield. This difference between earnings yield and dividend pay-out has not been fully explored.

The Fed model may again be useful, but not until there are Treasury yields that is not manipulated by unconventional policies. 

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