Wednesday, October 30, 2013

Are stocks cheap or bonds rigged? (excerpt)

I’m the fellow who observed that the Fed’s staff seemed to answer Greenspan’s question about whether the stock market was “irrationally exuberant” in the second section of the Fed’s Monetary Policy Report of July 1997. I noted that it included a chart comparing the 12-month forward earnings yield of the S&P 500 to the 10-year Treasury bond yield. I named it the “Fed’s Stock Valuation Model,” as noted in the Wikipedia article about it. Back then, the Fed’s ambiguous conclusion was that stocks were somewhat overvalued, but that might be justified by the rise in analysts’ consensus expectations for earnings growth over the next three to five years.

The Fed Model actually worked quite well in the late 1990s. It showed that the S&P 500 was 21% overvalued during the week of July 4, 1997. It was then undervalued by 16% during the week of October 9, 1998 as a result of the meltdown of LTCM. It didn’t take long after that for the market to be overvalued by a record 69% during the week of January 14, 2000. Greenspan got his answer. The bubble burst, and so did the usefulness of the Fed Model.

Since the start of the previous decade, the Fed Model has signaled that stocks were cheap relative to bonds. They got much cheaper during the last bear market from October 2007 through March 2009. Currently, the model shows that stocks are 63% undervalued relative to bonds. Or is it that bonds are overvalued relative to stocks because the Fed is keeping yields artificially low with its ultra-easy monetary policies?

Today's Morning Briefing: Detecting Irrational Exuberance. (1) Greenspan’s unanswered question about irrational exuberance. (2) The Maestro says stocks are cheap. (3) Fink says investors may be “overzealous.” (4) How to recognize irrational exuberance. (5) Why has the Fed Model been useless? (6) How much should we pay for subpar growth? (7) Bad news is good news until it isn’t. (8) S&P 500 diverging from fundamentals thanks to Fed. (9) A melt-up portfolio: betting that the first shall continue to be first. (10) Focus on market-weighted S&P 500 Retailers. (More for subscribers.)

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