Wednesday, February 6, 2013

S&P 2162: Understanding The 'Fed Model'

As the market drifts higher and higher and more and more bears scratch their heads in disbelief, I begin to wonder when they will admit that interest rates may have some relevance to equity valuations. I am not dogmatic in this regard and I do not think that there is a "magic formula" for calculating stock indices based on interest rates. However, it is useful to examine the analysis that has been done on this issue because it will provide some useful information as to why we are where we are and where we are likely to be going. One very plausible theory of the connection between interest rates and stock valuations suggests that the S&P 500 could easily move up to 2162.
In the 1990's, a leading securities guru - I believe it was Ed Yardeni - coined the phrase "Fed Model" and calculated the earnings yield on the S&P 500 in comparison with the interest rate on the 10 year Treasury. The earnings yield is the inverse of the price earnings ratio (PE); a 10 year Treasury interest rate of 8 would suggest an earnings yield of 8 and a PE of 12 1/2. The Model was presumably based on an "investor migration" theory under which investors would buy stocks and sell Treasuries until the earnings yield on stocks equaled the interest rate on 10 year Treasuries. Rates were coming down in the 1990's and stock prices were going up and people were looking for an explanation of what was going on in the stock market. I think that this model served as a kind of rationalization for what was happening without a sufficient explanation of the mechanism which would drive stock prices to the levels specified by the model. Of course, if you applied this approach to the current situation, it would suggest a PE of roughly 50 and an S&P 500 target of over 4300; most people reject this as implausible and this sometimes leads to a total rejection of the approach.

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Source: Philip Mause

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