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US - use P/E. Forget the FED Model

  1. From Comstock.
    Although stocks are highly overvalued by almost every metric—price-to-earnings (P/E), price-to-dividends and price-to-book—the bulls love to use the so-called Fed Model, which purports to show that stocks are now undervalued despite their current excessive P/Es. As we pointed out previously (see “A Flawed Model”, September 24, 2001), the Fed model has some serious problems. The various Fed models in use today are based on a model used by the Fed in its July 1997 Monetary policy Report to Congress. It is based on a comparison of the interest rate of the ten year U.S. Treasury Bond to the earnings yield (the inverse of the P/E ratio) of the S&P 500, using the estimate of operating earnings for the next 12 months.
    We have two major problems with using the Fed model. First, the model is based on earnings and interest rate numbers from 1979 to the present, a period that started with historically high interest rates. The current interest rate on the ten-year Treasury of about 4.3% is the lowest in the entire history of the model, meaning that the model is untested at the current rate. In addition the level of long-term rates was higher in 1979 than at any point in the prior 60 years. In those 60 years the P/E ratio ranged between 7 and 22 times compared with 38 times today. In other words interest rates were lower than today in 60 of the past 83 years, yet P/E multiples were never this high except for the late 1990s bubble. The model is theorizing a market valuation that is unjustified by real world historical experience.

    The second major problem is that the model uses 12-month forward operating earnings rather than trailing reported earnings. As we have stated numerous times, we believe that reported earnings are a more reliable indicator of corporate health than operating or pro forma earnings which arbitrarily ignores various types of expenses and is subject to all other kinds of abuse. Moreover, as documented in numerous studies, estimates of 12-month forward earnings have an extremely poor record for accuracy, and are usually highly overstated.

    We continue to believe that price-earnings ratios (using reported earnings) are the only measurement of stock market values that have withstood the test of time through all kinds of conditions. On this basis the market remains highly overvalued.

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