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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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Hocus Pocus pull that hood off your head. Stocks go up because they are connected directly to the FEDs infinite money supply. It is a computer thing.
Better Fed than dead.
ZH readers should be quite familiar with the fallacy of the Fed Model. It was covered quite succinctly just a few months ago.
http://www.zerohedge.com/news/2012-11-15/broken-fed-model-3-simple-charts
But, but, how else would my 401k stawks stay up?? I'm a dumbass plebe, and that's all it really takes to keep me docile. $Trillions well spent.
Stocks would ramp up as consumers will finallly have money to spend and shareholder sstarted holding the company managers to task.
Bernanke dangling at the end of a hangman's rope, now that would be a true Fed model.
the fed model when compared with wall street bonuses is a perfect match
The Fed is simply a contractor....albeit exclusive contractor to the Treasury...one that has largely not changed since its inception.
The US Government uses lots of contractors; i.e. Los Alamos Labs is run by a Bechtel-University of California combo, Sandia National Labs is run by Lockheed-Martin, and so on across the govt spectrum.
The USG needs to RECOMPETE the Fed's contract, same as they do with numerous other large scale govt contracts.
Do you guys really trust CONGRESS to manage the nation's money?.....I sure as Hell don't.
If they are given the proper rules to play by i would be ok with it.
I think they should operate with pure fiat and eliminate taxes. Limit growth of the budget to 2%. Anything above that requires a national referendum to levy taxes. It better be a damn good thing for it to be passed.
It could work but ultimately will keep bankers from get a portion of every dollar, thus the resistance you see here and everywhere in the financial world.
As long as the Blue Sky is around ... dump the income tax and tax consumption (i.e VAT) only. It forces savings and true investment and would right the listing ship of state. Keeping up with Jones would be a hell of a lot easier. Our whole economy is build on debt and consumption ... both of which will crush you in time.
This simply doesn't hold up in theory or practice.
Billshit - its working great - central planning is making all us bulls rich - BTFD
"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."
Isn't that why this QE is supposed to be open ended?
It's funny how many things quit working in that 71 to 73 period. Let's see what happened in 71 that might have changed everything? Hmmmmm..... Nixon was president.....
http://m.youtube.com/watch?v=iRzr1QU6K1o
Nixon is to blame for everything bad that happened since 1968.
Chart Heading: Wall Street Has Wanted Investors To Stay In Stocks.
Well, they wanted investors to stay in stocks, while they sold off to them at the top. They wanted investors to sell at the bottom, so they could pick up cheap shares to profit from.
At the top of the housing bubble, Cramer said he would never sell a Toll Brothers because it was a land bank. Good thing the Toll brothers didn't listen to him and dumped some 400 million worth of shares.
Good thing the Wall Street insiders didn't wait until Goldman took APPLE off its conviction buy list.
Wall Street games investors.
Fed drives down interest rates to zero and stocks are cheap relative to bonds, which should not come as a surprise. But today, EVERYTHING IS CHEAP relative to bonds. So why buy stocks? And more importantly, should the Fed no longer decide to floor interest rates, or for some reason no longer be able to, what happens to stock prices then? The argument that we should buy stocks because the Fed has manipulated bond pricing to yield close to 0% seems flawed and dangerous.
It is dangerous. But nonetheless, that is their plan which they are trying to force everyone to follow against their will. And the question is, who can hold out the longest; the Fed with it's infinite printing press, or you with your savings and bonds slowly erroding away to zero via inflation?
cant tell you how many professors i had that lived by these calculations. i never liked the idea but every financial anal lives by this shit......
Thank God It's Non-Farm Payrolls Friday
http://chartistfriendfrompittsburgh.blogspot.com/2013/04/thank-god-its-non-farm-payrolls-friday.html
"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...."
Golly-gee whiskers!
What a unforeseen and terrible shame! All that liquidity just stuck there in the top economic strata of our American Republic!
We are going to have an all Goldman Sachs MMA cage match between incoming Bank of England Governor Mark “Brutal Reckoning” Carney and the ECB's Mairo “Whatever it Takes” Draghi as different ideas emerge on how to deal with fragile and fragmented economies. Draghi appears to be for more QE and low interst rates while Carney has said stuff like "the bond market is there, until it isn't" and "cheap money is not a growth strategy. For a fun look at the cage match that is coming: http://tinyurl.com/c4dlrdt
Lots of discussion about an outdated model. The paper 'Understanding the Fed Model, Capital Structure, and then Some' by Timmer offers an alternative explanation that makes theoretical sense.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1322703