Guest Post: The Fallacy Of The Fed Model
Submitted by Lance Roberts of Street Talk Live blog,
On April Fool's Day Martin Hutchinson released an article entitle "This Little-Known Indicator Says Stocks Should Double." stating:
With the markets breaking all-time highs last week, it begs the question of just how high they can go. At 1,569 points the bears would say at this point the S&P 500 is completely overdone. With a sluggish economy and a growing federal deficit, you might be prone to believe them.
But there is a little-known indicator that became very fashionable between 1982-2007 that says something else entirely. Noted for its accuracy over that period, it actually suggests that stocks should double.
It's called the "Fed Model."
Now, before you assume that I am attacking Mr. Hutchinson's view point, I want to clarify that even he suggests that "...the Fed Model is only right by accident. However, lots of people follow it..." This is the primary point that I want to address which is the fallacy of the Fed Model.
While there are certainly reasons to be bullish about the financial markets currently, as their hover near historic highs, one of the simplest, most overused and popular assertions is that claim that stocks must rise because interest rates are so low. In fact, you cannot get through an hour of financial television without hearing someone discuss the premise of the Fed Model which is earnings yield versus bond yields.
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.
This simply doesn't hold up in theory or practice.
First, the Federal Reserve has been on an unprecedented mission to support the financial markets and the economy through outright manipulation of interest rates. The artificial suppression of interest rates through various interventions, such as Quantitative Easing, has distorted what bond yields would be in a more normal operating environment. Therefore, the yields do not reflect the inherent risk being undertaken by investors in terms of duration, credit or repayment.
The Fed's goal of suppressing interest rates was to ultimately boost employment and asset prices to spur economic growth. However, the problem for the Fed has been a failed transmission system which has left the "wealth effect" trapped at the upper end of the economic spectrum and has failed to do much more than keep the economy from slipping into a prolonged recession.
Therefore, with the yield curve artificially steep the effectiveness of the yield curve's recession predicting capability may be somewhat suspect this time around. This is something I can't prove at the moment - but I do think that time will tell that this time "may indeed be different." However, the reason I state this is that if we extract the influence of trillions of dollars of Federal stimulus though both the government (TARP, HAMP, HARP, etc.) and the Federal Reserve - the yield curve would likely look far different than it does today.
This brings us to profits and equity yields. Corporate profits surged since the depths of the financial crisis. However, as I discussed in our recent post on "The Great Disconnect: Market Vs. Economy":
"Corporate profits have surged since the end of the last recession which has been touted as a definitive reason for higher stock prices. While I cannot argue the logic behind this case, as earnings per share are an important driver of markets over time, it is important to understand that the increase in profitability has not come strong increases in revenue at the top of the income statement. As the chart below shows while earnings per share has risen by over 200% since the beginning of 2009 - revenues have grown by less than 10%.
As expected, since the economy is 70% driven by personal consumption, GDP growth and revenues have grown at roughly equivalent rates. Therefore, the question as to where corporate profitability came from must be answered? That answer can be clearly seen in the chart below of corporate profits per worker which is at the highest level in history.
Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth."
As the Fed's suppression of interest rates - given a more normal operating environment earnings yields would likely be less than they are today. The deflationary pressures on wages due to an excessively large labor pool, combined with accounting manipulation and record stock buybacks to boost earnings per share, have inflated the earnings yield to historically high levels. However, it is also within the context of these "record profits" that a warning bell should be sounding as "records" by any measure are usually more representative of a peak within the current trend rather than the start of one.
The Fed Model Is Broken
This bring us to the widely followed, overly espoused and internally flawed "Fed Model." The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa. That makes sense - until you actually think about it.
The problem here is twofold. First, you receive actual income from owning a Treasury bond, along with a return of principal function, whereas there is no tangible return from an earnings yield on stocks. Therefore, if I own a Treasury with a 5% yield and a stock with a 8% earnings yield, if the price of both assets do not move for one year - my net return on bond is 5% and on the stock it is 0%. Which one had the better return? This has been especially true over the last decade where stock performance has been significantly trounced by simply owning cash and bonds rather than equities. Yet, analysts keep trotting out this broken model to entice investors to chase the single worst performing asset class over the last decade.
It hasn't been just the last decade either with which the "Fed Model" has continually misled investors. An analysis of the previous history of the concept shows it to be a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50's and 60's the model actually worked pretty well as economic growth was strengthening. Interest rates steadily rose as a stronger economic growth allowed for higher rates which enticed higher personal savings rates. These higher savings rates were lent out by banks into projects that continued further stimulated economic growth.
However, as I have discussed in the past in "The End Of Keynesian Economics" as the expansion of debt, the shift to a financial and service economy and the decline in savings began to deteriorate economic growth the model no longer functioned. During the biggest bull market in the history of the United States you would have sat idly by in treasuries and watched stock skyrocket higher. However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost a large chunk of your principal after the crash of the markets in 2008.
Currently, you are back in again after missing most of the run up in the current bull cycle only most likely to be left with the four "B's" after the next recession ends - Beaten, Battered, Bruised and Broke.
The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine "WHAT" to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining "WHEN" to make an investment. In other words, I can buy fundamentally cheap stock all day long; however, if I am buying at the top of a market cycle then I will still lose money.
As with anything in life - half of the key to long term success is timing. Right now, with virtually all of the economic indicators weakening, rising geopolitical tensions, continued concerns from an ongoing recessionary environment in the Eurozone, valuations anything but cheap currently and an extremely overbought and extended market technically - timing right now could not be worse for long term investors to "jump in".
Could stocks double from here? Anything is possible, however, for investors the reality is that the current financial and economic environment is not extremely healthy because if it were the Fed would not need to be engaged in two simultaneous liquidity programs to keep it afloat. Without such support from the Fed, as we have seen after the conclusion of the previous Q.E. programs, the markets, and the economy, would quickly begin to contract.
It's time for the "Fed Model" to go the way of the "dodo." Of course, much like the "Mirror On The Wall" as long as it tells us that we are the "fairest of them all" what could possibly go wrong?
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