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The Models That Drove Stocks Up Now Aren't So Sure


The model used by the Federal Reserve to value the stock market (the Fed Model) takes the consensus expected earnings for a group of stocks (e.g., S&P 500) and capitalizes those profits using the 10-year Treasury yield. Voila - you have an estimate of fair value for stocks. Compare that to the current index price and you have a measure of whether stocks are over or undervalued. Here's what that series(1) looks like since 1979:

The red line shows the Fed Model fair value price. The blue line shows the actual price of the S&P 500 index. You can see the impact of low interest rates, particularly in 2020-2021 when the 10-year Treasury yield spent about 10 months under 1%, driving the red line to almost 30,000! It's not easy to see on the chart but the index is currently around 4,300 after peaking in January 2022 at almost 4,800. The 10-year Treasury yield is now approaching 4.5%.

While the Fed Model still says stocks are undervalued (red line is higher than the blue line), others are not so sure. Here's one example(2):

"When we plug a 10-year Treasury note yield of 4.30% into our capitalized profits model, it spits out a “fair value” estimate for the S&P 500 of 3,126. We are not predicting a drop that low in stocks, but this method makes us comfortable keeping a target of 3,900."

Or viewed another way - as Thompson Clark at Mauldin Economics(3) points out:

"Looking at the S&P 500, it currently trades at a forward multiple of earnings of around 18.5X (i.e., it trades for 18.5 times what analysts are forecasting for earnings over the next 12 months). Inverting this, the S&P 500 trades for an earnings yield of 5.4%...Right now, investors are only getting around 1%—or 100 basis points—of excess returns by purchasing the S&P 500…Big picture, the takeaway here is that finally, after 15 years, we can get a decent return on risk-free government bonds…The narrative post-financial crisis was TINA: “There is no alternative.” That is, investors must buy stocks if they want to get a positive return…Today, there is an alternative. Bonds are finally interesting, and they deserve a place in a balanced investment portfolio."

We don't use the Fed Model to make capital allocation decisions (for a variety of reasons). But many investors do, and for a long time this model told them that stocks are undervalued. But that appears to be changing - the model that pointed to "stocks up" for a long time is now not so sure.

More pressure on earnings (material costs, labor costs, financing costs) over the long run; higher Treasury yields potentially over the long run (at least, compared to what investors enjoyed since the 2008-09 financial crisis). The game has changed.

 

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