Excerpt from fund manager John Hussman's weekly essay on the U.S. market:
If you watch CNBC for a few minutes, you'll immediately hear some analyst claim that stocks are cheap because the "forward earnings yield" on the S&P 500 is higher than the 10-year Treasury yield. The next analyst will just say that "stocks look cheap compared with bonds." The next will offer some strange convolution of the so-called "Fed Model," like "Sure, P/E multiples are above average, but bonds are trading at a P/E of 21." After a short break from the monotony by some kind of circus clown playing with horns and buzzers, another analyst then comes on saying how the firm's "valuation model" (which is driven by forward operating earnings and interest rates) implies that stocks are 20% undervalued.
Wall Street is presently managing trillions of dollars of other people's money on the basis of a single toy model, originally discovered in a packet at the bottom of a Cracker Jack box. Despite the superficial appearance of being some sort of discounting model (with the earnings yield in the numerator and the interest rate in the denominator), the "Fed Model" doesn't actually map into any reasonable model of discounted cash flow valuation without making odd and counter-factual assumptions about the relationship between growth, payouts, interest rates, and risk premiums.
The Fed Model asserts that earnings yields and Treasury yields have a 1-to-1 relationship, that stocks are undervalued anytime the earnings yield on the S&P 500 is higher than the 10-year Treasury yield, and that the gap between earnings yields and interest rates is the prime determinant of subsequent market returns.
It speaks volumes about the shallow analysis on Wall Street these days that all of these beliefs can be dispelled in a single chart.
There is, in fact, no stable relationship between earnings yields and interest rates. The relationship is actually negative in data since 1929, is marginally positive (but statistically insignificant) in data since 1950, and is only strongly positive in data from 1980 through 2000 as a statistical artifact of the disinflationary period from 1980 to 2000...
Yes, there are a few instances where a positive or negative "spike" in the Fed Model was followed by favorable or unfavorable stock market returns, but all of those instances (and more) would have been captured by a simple rule: buy stocks when earnings yields are high and interest rates suddenly decline; sell stocks when earnings yields are low and interest rates suddenly advance.
In fact, I discovered a few years ago that the main usefulness of the Fed Model is to identify risks in the bond market -- specifically, when stock yields are low but the Fed Model gives a "buy signal" anyway, it is evidence that bond yields are unusually depressed. That signal is typically followed by poor bond market performance (with no reliable implication for stocks).
