What Happens When The "Fed Model" Breaks Down

Tyler Durden's picture

With stocks having reached nosebleed valuations which clearly make no sense, which event bullish pundits slam as absurd, and which every single bank has thrown up on and is urging clients to sell into what has clearly been a relentless central bank bid, there has been just one justification for the stratospheric prices attained by equities: the so-called Fed model, which argues that all that is needed for stocks to be high is for them to be cheap relative to bond yields, or in other words, the lowers global bond yields are, the higher stocks can levitate, completely dislocated from fundamentals.

Naturally, it is this dislocation that has forced so many hedge funds to face the greatest redemption wave since the crisis, or throw in the towel altogether, as this particular "model" is nothing more than a economic justification for an asset bubble, in this case one inflated by central banks who have created the biggest bond and stock bubble in history courtesy of some $2.5 trillion in annual liquidity injections...


... or as we called it, a slow-motion LBO of equity markets courtesy of central banks.


But what happens when the Fed model finally breaks? For the answer we go to perhaps the most prominent expert on the Fed Model, and specifically its collapse, SocGen's Albert Edwards, who writes in a recent note that "a key plank in our Ice Age thesis was that the Fed Model, so widely adhered to by the market, would break down."

According to Edwards, the seemingly stable relationship between bond and equity yields was a recent phenomenon. Indeed prior to 1957 the US equity dividend yield had always been above the 10-year bond yield. When the strategist formulated his infamous Ice Age thesis some 20 years ago, the big asset allocation call was that the Fed Model would break down and that 10y US bond yields (which were then 7%) would fall back permanently below the S&P dividend yield (which was then 2%) ? something which he says was "a most ludicrous, extreme forecast that got me a frosty reception!"

Edwards continues:

Our Ice Age thesis in 1996 called for an end of ?the long bull market? financial era and that we would enter the mirror image of the 1950-1965 period. We were, as usual, too early and the ?long bull market? and positive correlation between equity and bond yields continued until the end of 2000. But what we expected to occur did occur eventually and from 2000 equity and bond yields de-coupled and equity yields rose (PEs fell) despite bond yields and interest rates continuing to decline. It was indeed a mirror image of the 1950-1965 period, dubbed ?the culting of equities? (see chart below). The so-called Fed Model was finally broken.

So what tipped Edwards off on the failure of the Fed Model? Why Japan of course: that experimental monetary laboratory which central bankers have abused for 30 years with disastrous results, leaving Japan on the verge of becoming a failed state: "We knew the Fed Model would break down and equities would de-rate verses bonds because we had seen exactly the same thing happen in Japan ten years before (see chart below)"


According to Edwards, the chart above is a variant of the Fed Model but uses the inverse of the price/cashflow yield rather than the price/earnings ratio and the Japan ratio has been pushed forward ten years.

What is so startling is that the scale is the same on both sides ? ie this ratio peaked out at a very similar level in the US in 2000 as it did in Japan in 1990. We consistently believed, and do still believe, that there are key lessons to be learnt from the bursting of the Japanese equity bubble, and in many ways what has happened in the US and Europe since 2000 was wholly predictable.

So what is the implication of the Fed model's breakdown? If Edwards is right, it would be staggering.

One thing we learnt from Japan is that the equity secular valuation bear market takes many economic cycles to unfold and ends when equities are ?dirt cheap?. US equities did not get dirt cheap in March 2009 at a Shiller PE of 14x - they just got cheap. To be dirt cheap they needed to half again from the 666 level they reached. But why should we have expected this process to end in 2009 as it was only the second recession from the valuation peak of 2000? Historically the shortest secular valuation bear market has taken four recessions to play out.

Or, said otherwise, it will get worse, before it gets much worse: so bad in fact, that the S&P could plunge to under 400. And it would be downhill from there:

We also learnt from Japan that each successive recession caused equity valuations to slump to new secular lows. And history shows that is exactly the case too in previous US secular valuation bear markets (with recessions shown in red on the top line above).

Alberts conclusion:

Most investors are currently neglecting the longer-term context of this secular bear market. Relying on Tina will prove disastrous. The last three years have seen equity yields re-couple with bond yields and it has beguiled investors that ?normality? has returned (circle in chart below). If I am right (and I am on occasion), this is merely a brief interruption in the secular de-rating of equities and the next (imminent?) recession will bring devastation to Tina-loving investors.

Judging by today's market collapse, Edwards may indeed be right as the TINA divorce proceeding appear to have begun.

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offwirenews's picture

Gonna be one hell of a v-shape. This will be a 3:30 to end all 3:30's.

bleu's picture
bleu (not verified) bamawatson Sep 9, 2016 8:32 PM

The Fed was created to enrich a tiny minority. http://wp.me/p4OZ4v-ux

SomethingSomethingDarkSide's picture

TVIX redemption, yeeeeeeeesh, long overdue

GunnerySgtHartman's picture

But what happens when the Fed model finally breaks?

Everything goes to hell courtesy of the central bankers ... unless you dumped your equities and bought PMs.

This is going to be really, really ugly.

101 years and counting's picture

under 400?  one can only hope.

asteroids's picture

Wouldn't be surprised if we opened down 20 or 30 points on the SPYs Monday and finished green.

Dr. Darkpool's picture

The big reset. Buy the dip and bring a change of skivies.

lasvegaspersona's picture

The primary reason to buy stock for most individuals is to get a return higher than inflation over the long haul. Otherwise saving in gold would be preferable. We want to spend our savings when we no longer have income. the negative yield of current bonds will force savers into gold even if the markets are 'managed'.

Probablly things will break first however...so nothing matters.

lasvegaspersona's picture

One more thing...the Fed will definitely maybe raise rates this month....OMG I'm dying laughing here....someone tell Trump he's already won if they do....it's HILLAR-Y-OUS

Seasmoke's picture

Yellen goes straight to He'll. 

Zarbo's picture

So, Tina is getting divorced.  Who is she, and is she related to TINA?  Three references, but no definition.  

docmac324's picture

But what happens when the Fed model finally breaks?


Nothing, they reset the game how they wish, and it starts all over.  They win you lose.

Yen Cross's picture

   How pathetic is this?        S&P 500 VIX    16.67    +4.16    +33.25%   

  UP 33.00% and it's only 4 points.!!!

Jtrillian's picture

Three words...

Keep stackin.

NAV's picture

“Could it be,” Mike Whiney writes, “that the Fed is not really the ‘independent’ institution its proponents claim it to be, but the policymaking arm of the big Wall Street investment banks and the mega-corporations that arbitrarily impose the policies that best serve their own profit-making ambitions?”

Stop the Fed Before it Kills Again |Counterpunch

by Mike Whitney

September 9, 2016 --Why has the Fed created incentives for US corporations to loot their companies and drive them deeper into debt?

Despite four consecutive quarters of negative earnings, weak demand and anemic sales, US corporations continue to load up on debt, buy back their own shares and hand out cash to their shareholders that greatly exceeds the amount of profits they are currently taking in. According to the Wall Street Journal: “SandP 500 companies through the first two quarters of the year collectively returned 112% of their earnings through buybacks and dividends.”

You read that right, US corporations are presently giving back more than they are taking in, which is the moral equivalent of devouring one’s offspring.

These companies have all but abandoned the traditional practice of recycling earnings into factories, productivity or research and development. Instead, they’re engaged in a protracted liquidation process where the creditworthiness of their companies is used to borrow as much money as possible from the bond market which is then divvied up among insatiable CEOs and their shareholders. This destructive behavior can be traced back to the perennial low rates and easy money that the Fed has created to enhance capital accumulation during a period when the economy is still mired in stagnation. The widening chasm that has emerged between the uber-wealthy and everyone else since the end of the financial crisis in 2008, attests to the fact that the Fed’s plan has succeeded beyond anyone’s wildest imagination. The rich continue to get richer while the middle class drowns in an ocean of red ink…


The Fed is untouchable because we don’t have representative government anymore. If the Founders had been told that the federal government and the federal courts would have the power to overrule everything a state does, not one state would have ratified the US Constitution. But yet, it has happened. And the reason is that America's Congressmen are being bought and sold by oligarch bankers like they were real estate.

itstippy's picture

How much would you pay for stock in a corporation with declining revenue, negative profits, huge debt overhang, and hasn't spent any money on research & development of new products for years?  What if their profitable patents are expiring, their once-valuable brand is tarnished from selling shoddy goods for a decade, and they have more financial engineers on the payroll than they do real engineers?  

Fundamentals will matter again eventually, and a lot of people who think they're "financially savvy" because they read Fortune, Barons, and The Wall Street Journal will be most rudely awakened.

jm's picture

History rhymes but it doesn't repeat. 

The Fed and ECB learned from the Japanese experience:  throw money at it and don't hold off.  The BOJ consistently tightened or worse, the gov riased taxes over the years, causing the Nikkei to drop as it did.

I have no doubt that we are in for a drop in equity prices, but short of central banks unwinding their balance sheets you aren't going to see S&P500 at 333.




JailBanksters's picture

You get a new fed chair, that does exactly the same as the old chair but it gives the Illusion that things are changing.

Not that different to choosing a President really.

Change you can believe in.

Blopper's picture

I don't think there will ever be a downhill from here NO MATTER how similar is our situation to Japan's during the 90's for few major reasons:

1. The Japanese BoJ did not commit to massive asset purchases as they have and are doing today.

2. ECB and Fed are, and will continue with massive asset purchases going forward.

3. If the S&P 500 can go to 666 again, or even to 333, then cash would be extremely highly valued again, and prevent any emergence of a new monetary system, defeating the globalized banking sinners' intention to crash the dollar as well as other currencies. The only way a new monetary system can be brought forward is when the dollar and other currencies are almost totally worthless that a new system is required. If the dollar gets highly valued because the stock market level gets dirt cheap, then such new monetary system would not be applicable. Thus a cheap S&P 500 is not going to happen from now onward. A near-worthless dollar is the same as a near-bubble S&P 500. The S&P 500 is not yet at near-bubble state, especially when the dollar is not yet at near-worthless.

Blopper's picture

Tyler Durden keeps talking about a crash/collapse prompting everyone to just sell, sell and sell.

I wonder if:

1. Tyler Durden has limits in his understanding of the fundamentals at a much more subtle/profound level.

2. Tyler Durden does not understand the main goal of the globalized banking sinners in bringing forth their new monetary system.

Because if Tyler Durden is not suffering from any of the above, he would talk about buy, buy and buy.

Yes, everything economic is rotten now, but what we need to do is against logic and senses, not because fundamentals don't work, but because the game we are playing is totally rigged. A game that is rigged does NOT follow science or fundamentals.

Storm Chaser's picture

No surprise "Tyler Durden" dug up this old Edwards piece on the heel of one big down day.

Edwards' Ice Age thesis has two main themes:
1. Watch Japan's SECULAR "de-rating" of equities which takes 4 cyclical recessions (we only had two: 00 and 08) to complete
2. Recent equity yields re-coupling with bond yields (i.e. the lower global bond yields are, the higher stocks can levitate ) has beguiled investors into believing normality has returned.  Instead, this may merely be a brief interruption in the secular de-rating of equities.

If the US equity market had only recovered half of the loss in 2008, then this thesis is believable.  But the US equity market is at levels above both 2008 and 2000 peaks!  Does not fit the description 'brief interruption in the secular de-rating of equities'!  We have something ELSE going on here!