From the Editor - May 06

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

So What Is the Fed Model?

In every issue of The Prudent Investor we make reference to the “Fed Model” or the “Modified Fed Model.” But to date, we have not offered our readers a fuller explanation of this important metric. This month we’d like to take some time to discuss just what it is, and why you should care about the Fed Model results as they change over time.

The Fed Model is a very simple model that can be used to compare the relative valuations of fixed income (e.g., bonds) with that of equities. It helps to answer the difficult question of “what is fair value” for the overall stock market. There are dozens of metrics and approaches used to answer this all-important question, some simple, but most rather complex. We might argue that, when all is said and done, “fair value” is simply the price a willing buyer will pay (without compulsion) to a willing seller. Or, in other words, a given price for something (whether stocks, or cars, or real estate) may be considered fair as long as both buyer and seller freely agree to enter into a transaction at that price.

While our over-simplified definition of “fair price” or “fair value” may be accurate, it is also largely useless in helping an investor to make buy and sell decisions, or in trying to identify such things as market bubbles or attractive buying opportunities. That’s where a model such as the Fed Model comes to the rescue.

The Fed Model, or more fully the “Fed Stock Valuation Model,” is so-named because the Federal Reserve board began using it several years ago as a tool to help identify froth in the stock market. If our memory serves us correctly, it was implemented shortly after then-chairman Allen Greenspan announced that, in his opinion, the stock market was exhibiting “irrational exuberance.” His comment elicited much angst and volatility in the markets, and remains among the most memorable of all comments he made as Fed chairman. After the infamous comment, Mr. Greenspan asked his staff to provide him with a meaningful metric for actually quantifying “irrational exuberance” (translation: “bubble”) in the stock market. The Fed Stock Valuation Model was what he received. Ironically, it turns out the Fed Model showed that the market was fairly valued, rather than overvalued, at the time he made his famous proclamation!

After all the above as a way-to-lengthy introduction, you still may be asking, “What is the Fed Model?” In brief, it is a simple but robust model that compares the relative valuation of bonds (fixed income) to stocks (equities). We stress the word relative because it makes no attempt to say whether a given bond yield is too high or too low, or whether the overall stock market is priced too high or too low for a given value of aggregate earnings from all companies. It simply takes the values of both bonds and stocks and compares the two to show which of the two represents a more attractive valuation at any given point in time.

How is it possible to compare the value of a fixed income security like a bond to an equity like a stock? Bonds are typically valued based on their yield to maturity. For example, a bond that is priced to yield a 7% return to its owner is a better value than a similar bond priced to yield 5%, all else being equal. But to compare a bond yield with a common measure of a stock’s valuation, the price to earnings ratio (P/E), you have to do a little math. Turns out, not much math. Just flip the P/E so that you have E/P, or earnings divided by price. If you think about it, E/P is very analogous to a bond yield. Both represent the amount of earnings provided by the investment for a given price. It’s just that for the stock, the company doesn’t actually pay you all those earnings, but instead reinvests them in the company to make a higher E later on.

Calculating the Fed Model Results

Economist Ed Yardeni claims to have coined the actual term “Federal Reserve Stock Valuation Model” (FSVM). Whether true or not, he certainly deserves full credit for making most investment professionals aware of the term and concept. The following is his description of how the model works:

“The Fed model shows a strong correlation between the S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E) to the price index for the S&P 500 companies (P), using 12- month-ahead consensus earnings estimates compiled by Thomson Financial First Call—and the 10-year Treasury bond yield (TBY). The average spread between the forward earnings yield and the Treasury yield (i.e., FEY-TBY) is 29 basis points since 1979. This near-zero average implies that the market is fairly valued when the two are identical:

1) FEY = TBY

“Of course, in the investment community, we tend to follow the price-to-earnings ratio more than the earnings yield. The ratio of the S&P 500 price index to expected earnings (P/E) is highly correlated with the reciprocal of the 10-year bond yield, and on average the two have been nearly identical. In other words, the “fair value” price for the S&P 500 (FVP) is equal to expected earnings divided by the bond yield in the Fed’s valuation model:

2) FVP = E/TBY

The graph below shows how closely the Fed Model has tracked the S&P 500 price index over the past 20+ years. The two lines are remarkably close together over the entire time period!

Using the Fed Model to Enhance Returns

Next month we will discuss just how much better your returns can be when using the Fed Model as a tool to guide your investment decisions in stocks and bonds. We will also discuss, if time and space permits, why The Prudent Investor has elected to use a slightly modified version of the Fed Model. There are actually two key modifications we make. One is related to the earnings estimates we use to calculate the “earnings yield” of the S&P 500 index and the other is related to a more recent (and temporary) change in how we calculate the bond yield. You are likely to be amazed at how well the Fed Model can act as a tool to enhance your overall returns while at the same time reducing your risk in the markets. Next month will make for an interesting conclusion.