The current stock market run-up is the longest in U.S. history. As a result, equity valuations have hit overvalued levels based on many metrics. For example, the PE ratio is pointing towards lower future long-term returns. And here are five other bear market indicators. Although, they fail to factor in a vital trend over the last four decades…
Interest rates have trended down since 1981. The 10-year treasury yield has dropped from about 16% to below 2% today. This seismic shift has made it harder for yield-seeking investors – even after adjusting for inflation.
To factor in lower interest rates with the stock market valuations, we can use the Fed and Yardeni Models. I first learned about these models when studying for the CFA exams. Let’s dive in…
What is the Fed Model?
The Fed Model shows long-term government yields compared to the stock market’s earnings yield. It asserts that the S&P 500 earnings yield should be equal to the 10-year treasury yield. Here’s the formula…
Fed Model Formula: E/P = 10Y Yield
The earnings yield (E/P) is the inverse of the PE ratio. It shows the amount of earnings per dollar invested.
For example, if the stock market has a PE ratio of 20, then the earnings yield is 1/20 or 5%. So for every dollar you invest, you earn $0.05 each year – all else equal. This means a higher earnings yield is more attractive to investors.
The Fed Model implies the stock market is undervalued when the earnings yield is above the 10-year treasury yield. To see this in action, let’s look at historical data. Here’s the S&P 500 earnings yield to the 10-year treasury yield since the 1960s…
Since 2002, the Fed model shows that the stock market is not overvalued. And the long-term trend of the ratios sticking together has diverged in the last decade.
In this lower interest rate world, paying more for lower earnings is easier to justify. Other investments like bonds aren’t yielding as much. This new normal has even led legendary investors like Warren Buffett to say high stock valuations make more sense.
Statistics Note: Historical data is the best we have to make future predictions. But old trends don’t always persist and new averages take root. This is what’s called a non-stationary or regime change. I’m always hesitant to say this time is different, but lower rates have changed the game. There’s a lot of cheap money sloshing around pushing up asset valuations across the board.
The Fed Model is useful and provides a unique view for equity valuation. But it can be further improved upon…
What is the Yardeni Model?
The Yardeni Model is similar to the Fed Model but it includes factors for company risk and earnings growth. Here’s the Yardeni Model formula…
Yardeni Model Formula
Instead of using the 10-year treasury yield, it uses the Moody’s A-rated corporate bond yield and the 5-year earnings growth forecast. This formula showed up in the CFA study material and is useful to know.
I haven’t collected the historical data to show the Yardeni Model at work. Although, it should be giving a similar picture with lower interest rates. If you have historical earnings growth estimates, please pass them my way and I’ll chart the data. Just drop a comment below.
Final Thoughts on Equity Valuation Metrics
Popular equity valuation metrics point towards overvalued levels. But they don’t tell the whole story. It’s always good to remember that we can use data to paint any picture. So it’s good to be aware of that and seek out contradicting information.
The Fed and Yardeni models lend a hand here. Warren Buffett and other top investors have also mentioned the change in market valuations based on interest rates. And when they speak, it’s usually good to listen.
I enjoy looking at top-level market data and following proven investors. On top of that, I take a play right out of Buffett’s playbook…
I try to ignore overall market moves and news when making investment decisions. I look for individual companies trading at attractive valuations. This contrarian mindset has worked well and I picked up shares of Altria just over a month ago. I’m up about 20% and hope to hold the position for many years to come. Here are 10 Reasons I Bought Shares of Altria.
Please let me know if you have any questions or want to see other research. You can leave a comment below our reach out directly.