In a short series titled The Truth About Valuation we explained that:
“The Fed Model has been embraced by Wall Street cheerleaders as a simple and “reliable” method for estimating stocks intrinsic value. Note that simple is the key word in that last sentence, as it conveniently takes less time to calculate which provides strategists with much more time to shake their pom-poms. In any event, the so called Fed Model is a straightforward comparison of earnings yields (the inverse of price-to-earnings multiples) and treasury yields. When earnings yields are higher than treasury yields, so we are told, stocks are attractive and vice versa. Sounds intuitive and is certainly easy to grasp.” But, “there is almost no relationship between the two data sets (earnings yields and Treasury yields) with the notable exception of the period since around 1980. What an amazing coincidence that this is the only period that “the street” has chosen to examine.”
The “Sunshine Pumper Strategists” are out in full force today, with earnings yields on stocks spiking higher than those available on bonds. So we were pleased to see that Ron Griess at The Chart Store provided us with a couple of charts this morning that illustrate this relationship (or lack thereof) over time. Ron’s long term perspective is critically important here, as any monkey can easily pick out a few bananas that accurately predict the market at any given moment in time. But we would not invest our client’s capital (or our own for that matter) based on one monkey’s bananas. Instead, we’d prefer to focus on those few characteristics (i.e. normalized valuation) that consistently add value as a predictor of long-term returns, throughout history. As such, I sent Ron an email this morning complaining that if one more strategist tells me that stocks are cheap because their “earnings yield” is greater than the yield on bonds, I may puke. As Ron was concerned for my stomach, he was kind enough to grant us permission to share this charts with our readers. And also offered up the following colorful commentary.
“Too many of the “sunshine pumper strategists” draw their conclusion first, then look for supporting evidence. I know of one, who is a subscriber, and knew there must be others out there who were pounding the table with the earnings yield argument because I was getting requests for charts. I’m sure most of them are showing a chart of 10 or 20 years to make their “positive” case to BUY stocks. I know another portfolio-manager-type subscriber was very disappointed to learn that yet another reason to “buy ‘em” did not hold water if one looks at “the rest of the story,” i.e. far enough back in history.”