From Institutional Investor:
Investors today have good reason to worry about stocks. Europe, the US and emerging markets are facing real problems today — and economic recoveries after financial crises almost always take longer than recoveries after ordinary downturns. The global economy may take several more years to fully recover from the credit crunch, and so may the stock market. Both could weaken again before getting better.I don't know of anyone who is using the "Fed Model" under the current interest rate regime.
Indeed, our research has found that after 15 systemic banking crises around the world, the stock market took nine years on average to regain its prior peak. We don’t know if the recovery from the recent crisis will take a longer or shorter time than average, but assuming it is average, we’re now about halfway through.
But even taking these risks into account, we don’t agree with those who argue that the stock market is overvalued. To begin with, it doesn’t make sense to say the market is expensive, given where bond yields are today....MORE
Barron's June 9, 2012
The Flaws in the Fed Model
There are perfectly reasonable arguments that can support an upbeat outlook on the stock market. Unfortunately for crafters and consumers of sound bites, one of the simplest and most popular bullish assertions is irrelevant.
This is the common, intuitive, yet specious claim that because yields on 10-year Treasury notes are near record lows at 1.64%, stocks are so flattered into appearing cheap by comparison that surely they must rise. The only way to watch an hour of financial television without hearing that one is to hit the mute button.
The idea here, once formalized as the "Fed Model," is that stocks' "earnings yield" (reported or forecast operating earnings for the S&P 500, divided by the index level) should tend to track the Treasury yield in some fashion. With this earnings yield now above 7%, based on a trailing price-to-earnings ratio near 13, this model and its various offshoots render equities a no-brainer buy. Or, if one prefers, that Treasuries are in a reason-defying bubble.
This simply doesn't hold up in theory or practice. The Fed Model only "worked" as a predictor of market action in the 1980s and '90s, when bond yields were steadily descending and stock values consistently rising as inflation and interest rates were slowly strangled. Both before that period and since, the Fed Model relationship has been mostly a non sequitur in terms of foretelling market performance....MORE