The “Fed Model”
From the Wall Street Journal
The Fed Model: Fix It Before You Use It
May 1, 2005
Thanks to two months of slumping share prices, stocks are now a much better value than bonds. But long-run stock returns could still be thoroughly mediocre.
This good news-bad news story is based on the Fed model, one of the most widely used and abused stock-market valuation models.
Fancy yourself as an amateur investment strategist? Here's what the Fed model is all about -- and how you can try it at home.
Model Behavior
In the 1980s and 1990s, market commentators argued that falling interest rates justified higher and higher share prices. This notion became formalized in the Fed model, so called because it is purportedly favored by Federal Reserve Chairman Alan Greenspan.
For investors, there's a lot to like about the Fed model, which involves comparing the yield on the benchmark 10-year Treasury note with the earnings of the Standard & Poor's 500-stock index. Not only did the model work well in the 1980s and 1990s, but also it's so simple that almost anybody can use it.
To do so, you first have to find out the S&P 500's forecasted earnings. That figure is available at www.spglobal.com, the Web site for Standard & Poor's, a unit of McGraw-Hill. Click on the link for "S&P 500 Index Earnings" and then call up the spreadsheet labeled "S&P 500 Earnings and Estimate Report."
According to the site, 2005's reported earnings should come in at around 67.40. This earnings estimate is calculated so that it's comparable with the index value for the S&P 500, which lately has been trading around 1150.
Usually, investors would divide that 1150 by the forecasted earnings of 67.40. That would give you the market's price-to-forecasted earnings multiple, which is currently 17. But for the Fed model, you reverse the calculation, dividing the 67.40 earnings by the 1150 index value, thus getting an "earnings yield" of 5.9%.
You then compare this 5.9% to the 10-year Treasury's 4.2% yield. When the earnings yield is above the Treasury yield, as it is today, that suggests stocks are cheaper than bonds.
To be sure, bond investors get their interest in cash, while shareholders receive only a sliver of earnings as dividends. The rest of a company's profits are plowed back into the business, with a view to clocking additional growth. Still, presumably management could stop pursuing growth and instead pay out pretty much all of a company's earnings as dividends.
Failing Grade
Seem reasonable? Unfortunately, there are a bunch of problems with the Fed model.
For starters, the model is often biased toward stocks. Instead of reported earnings, fans of the Fed model often use operating earnings, which are higher because they ignore one-time accounting charges. To make matters worse, analysts are typically too optimistic in their earnings forecasts, further boosting the stock market's apparent earnings yield.
Until 2001, the S&P 500's earnings yield was often compared with 30-year Treasury bonds. But when the government announced in late 2001 that it would stop selling 30-year Treasurys, Fed model users gravitated to the 10-year note instead. Because the 10-year note had a lower yield, that immediately made stocks more appealing -- or so said the Fed model.
But the model's biggest problem is that bond yields and earnings yields really aren't comparable. After all, Treasury-bond interest is fixed for the life of the bond and you can count on receiving it every year.
Meanwhile, corporate earnings are iffier, but they should rise over time. Indeed, even if a company paid out all of its earnings as dividends, the company's profits would still tend to climb along with inflation.
Measuring Up
There is a way to fix these problems, contends Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School and author of a new book, "The Future for Investors."
Instead of using conventional 10-year Treasurys in the Fed model, he suggests substituting 10-year inflation-indexed Treasury notes. With these inflation bonds, you earn the inflation rate plus a small additional yield, currently 1.6%. Because inflation bonds and the interest they pay grow along with inflation, this 1.6% is truly comparable to the S&P 500's 5.9%.
Today, as you can see, the earnings yield is much higher than the inflation-bond yield. This is no great surprise. Stocks are riskier, so the expected return ought to be higher. The key question: How much extra should stocks yield?
Over the past eight decades, the S&P 500 has outpaced government bonds by five percentage points a year, according to Chicago's Ibbotson Associates. But Prof. Siegel reckons the margin of victory will be somewhat smaller in the years ahead.
In fact, he figures stocks would be fairly valued if the earnings yield were two to three percentage points above the yield on inflation-indexed Treasurys. The implication: With stocks today yielding four percentage points more than inflation bonds, either stocks are cheap -- or, as Prof. Siegel suspects, bonds are expensive.
Cliff Asness, managing principal of hedge-fund manager AQR Capital Management in Greenwich, Conn., has been a vocal critic of the Fed model. He says using inflation bonds, rather than conventional Treasury notes, is a big improvement. "Jeremy's changed it from mathematical garbage to a legitimate model," Mr. Asness says.
He also says that it would be reasonable for stocks to be priced to deliver two to three percentage points a year more than bonds. "There's a good argument that says people have done too well in stocks historically and they ought to accept less," he says. "The question is, will they?"
As Mr. Asness sees it, investors use the Fed model to justify their bullishness on stocks. But he isn't sure they are willing to accept the implied lower returns.
Suppose annual inflation comes in at 2.5%, inflation bonds give you 1.6 percentage points more than that and then stocks outpace inflation bonds by four percentage points a year. Add it up, and you are looking at an annual stock-market return of just over 8%, and possibly less if today's earnings forecasts are too optimistic.
What if investors decide that sort of return is inadequate? The Fed model may say stocks are a bargain. But that doesn't mean shares won't get a lot cheaper.