Blog

Is the Fed Model a Good Valuation Tool?

Should investors use bond yields as a baseline to determine if stocks are over-or-under valued?

If you believe in the “Fed Model,” your answer is “yes.” The model instructs investors to compare the S&P 500’s earnings yield (Earnings/Price, the inverse of the P/E ratio) to the 10-Year Treasury yield:

  • If the Earnings Yield is above the Treasury Yield, stocks are said to be “undervalued.”
  • If the Earnings Yield is below the Treasury Yield, stocks are said to be “overvalued.”

With the Earnings Yield (“EY”) today currently above the 10-Year Treasury Yield (“TY”), many pundits are arguing that stocks are still undervalued (and therefore attractive), despite other metrics indicating otherwise (click here for recent post on this). Are these pundits correct? Is comparing the Earnings Yield to Treasury Yields an effective way to value stocks and forecast future equity returns? Let’s take a look…

Data Sources for all charts/tables herein: Robert Shiller, Bloomberg, YCharts.

Going back to 1928, we can separate EY minus TY into deciles, from lowest (-4.4% to -2.1%) to highest (7.0% to 14.9%). We can then calculate average and median forward returns over the next 1 to 10 years within each decile…

If you’re struggling to find a strong relationship in the above tables, that’s because there isn’t one. While the highest EY-TY decile is indeed followed by the strongest returns, the lowest EY-TY decile has above-average returns from 4 years through 10 years forward. The weakest returns reside in the middle deciles (4-7), with a slight bias to higher forward returns with higher EY-TY starting levels.

We can observe this bias in the upward slope of the trendline line in the scatter chart below, which compares the starting EY-TY levels to forward 10-Year Total Returns. The R Squared in this case is .11, meaning that knowledge of EY-TY accounts for only 11% of the variation in future 10-year returns.

Why is there a correlation between EY-TY and forward returns at all?

Digging into the data, we find our answer. In the highest EY-TY decile 10 which showed the strongest forward returns, the median P/E ratio of 9 was by far the lowest of any decile, and the median earnings yield of 11.1% the highest. Many of the data points were from the late 1940s and early 1950s when stocks were exceptionally cheap and bond yields were exceptionally low.

Deciles 8 and 9 also showed below-average P/E ratios.

So perhaps the strong forward returns in deciles 8-10 were not due to the wide spread between EY and TY after all, but simply because of the lower starting P/E ratios (or higher EY).

If this is indeed the case, we should observe a stronger relationship between EY and forward returns than EY-TY. That is exactly what we find. The R Squared between EY and forward returns moves up to .45, meaning 45% of the variation in forward 10-year returns can be explained by the starting Earnings Yield. This is significantly higher than the R Squared of 0.11 for EY-TY.

The conclusion: cheap stocks tend to be followed by above-average forward returns – and expensive stocks below-average forward returns – regardless of where bond yields are.

This makes intuitive sense, particularly when viewed in the extreme. Let’s say the 10-year Treasury Yield went negative, as was the case in recent years in both Japan and Germany, and still is the case in Switzerland. Under the “Fed Model,” that would imply that the P/E ratio could literally go to infinity and still deliver a higher Earnings Yield (E/P) than the yield on bonds. If the P/E ratio on Swiss stocks went to 1000, the Earnings Yield would be 0.10% (=1/1000), still higher than the yield on 10-Year Swiss Bonds (-0.10%).

Would you call Swiss stocks undervalued today at a P/E ratio of 1000? I rest my case.

***

Related Posts:

What is the Relationship Between Interest Rates and Valuations?

Just How Overvalued Are US Equities?

Valuation and Bear Markets?

When Mean Reversion Fails?

To sign up for our free newsletter, click here.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Charlie is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.

In 2017, Charlie was named the StockTwits Person of the Year. He has been named by Business Insider and MarketWatch as one of the top people to follow on Twitter and his work has been featured in Barron’s, Bloomberg, and the Wall Street Journal.

You can follow Charlie on twitter here.

Disclosures:

Pension Partners, LLC is a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. For more information about Pension Partners please visit: https://adviserinfo.sec.gov/ and search for our firm name.

The information herein was obtained from various sources. Pension Partners does not guarantee the accuracy or completeness of such information provided by third parties. The information given is as of the date indicated and believed to be reliable. Pension Partners assumes no obligation to update this information, or to advise on further developments relating to it.

Past performance is not indicative nor a guarantee of future results.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

 

Facebooktwittergoogle_plusredditpinterestlinkedinmail
  • Posted in Equities, Valuation
  • Comments Off on Is the Fed Model a Good Valuation Tool?

Comments are closed.