Wednesday, May 20, 2015

Valuation & the Fed Model (excerpt)

Valuation like beauty is in the eye of the beholder. With bond yields at historical lows, why shouldn’t valuation multiples be at historical highs? At 2%, the 10-year Treasury bond yield has an effective forward P/E of 50, implying that stocks trading at a forward earnings yield of 5.9% and a multiple of 17 are grossly undervalued by as much as 62%. Of course, this “Fed Model,” as I first named it back in July 1997, has been showing that stocks are undervalued since the Tech bubble burst. Furthermore, historically low interest rates may be a sign of secular stagnation, which isn’t particularly bullish.

Previously I’ve argued that valuations are being driven by equity purchasers who don’t pay much attention to valuations. They are corporate managers buying back their shares because the forward earnings yields on their shares exceed their borrowing cost of capital in the bond market. As far as they are concerned, beauty is measured by the appreciation of their stock price as they buy back their shares. In this scenario, the source of irrational exuberance is the ultra-cheap money available in the bond market for share buy backs and M&A thanks to the ultra-easy monetary policies of the Fed.

Today's Morning Briefing: Beauty Contest. (1) Episode 42 in The Twilight Zone. (2) Different strokes: Dear Leader vs. King Kong. (3) Some pushback on valuation. (4) Irrational Exuberance Zone. (5) The 3 scenarios again. (6) Channeling the Tech bubble. (7) Record PEG for S&P 500. (8) Smithers & Co. on Tobin’s Q. (9) Does valuation matter? (10) Do interest rates matter? (11) Draghi renews his vows. (12) Front-end loaded QE. (13) Lackluster recovery in Eurozone. (More for subscribers.)

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