July 10, 2005
FED MODEL T:
What's a fair value for stocks? (ELLEN SIMON, 7/10/05, ASSOCIATED PRESS)
The standard metric for valuing individual stocks-- and markets-- is price-to-earnings ratios, or P/Es. The problem: Investors disagree on what a fair P/E is. In a report released Tuesday called "Nobody knows anything: Thoughts on equity market valuation," Keon wrote, "By now, shouldn't there be more widespread agreement on what constitutes a fair market P/E?"Those who want to buy only when markets are cheapest look for P/Es below 15.7, the historical mean. "They love the market when the P/E is 8 to 10," Yardeni said. "The only problem is, (at that point) the rest of us are unemployed or worried about being unemployed."
Comparing the current P/E ratio for the Standard & Poor's 500, which is about 19.5, to the historical mean P/E is how InvesTech's Stack determined stocks were 20 percent overvalued.
Stack also watches P/Es in relation to interest rates. Higher valuations tend to be supported by lower interest rates, Stack said.
"The last two times we saw a single digit P/E for the S&P 500 were 1982 and 1974, both instances where short-term interest rates were 8 percent or higher" he said. When interest rates increase, money market funds and bonds become more attractive.
"Today's low level of interest rates are providing an important buoyancy to the market and to market valuations," he said.
Another popular model is called the "Fed Model," because the research behind it was done by Federal Reserve staff and because believers think it's something Fed Chairman Alan Greenspan considers as he soaks in the tub. The Fed Model takes the ratio of stocks' earnings-to-prices, which is their "earnings yield," and compares it with the 10-year Treasury bond yield. Under the model, when the earnings yield is higher than the bond yield, stocks are a bargain.
Fed Model computations were part of the reasoning behind Keon's "100 percent stocks" report. Keon computes his earnings yield using analysts' projection of earnings. When figured this way, the Fed Model is usually bullish on stocks, and Keon's computations are no exception. He finds the earnings yield for stocks is around 6.6 percent, while the yield on the 10-year Treasury bill has been hovering around 4 percent.
"Stocks look as cheap compared to bonds today as they looked expensive in early 2000 at the height of the equity bubble," he wrote. "Either stock valuation should rise or bond prices should fall or a combination of both, according to the model."
Which at least helps to explain why Alan Greenspan has developed the habit of raising rates into the teeth of deflation. Posted by Orrin Judd at July 10, 2005 12:00 AM
Bonds are way too high. The 10 year ought to be at 6.5%. Stocks are probably fairly valued and the market is not going anywhere, until the oil situtation is resolved. The futures point to a leveling off of oil prices. But, unless supply is stabilized by an end of the iraq war and the spreading of democracy in the middle east, and south and east asian demand cools off, they wont' go down.
Posted by: Robert Schwartz at July 10, 2005 10:54 AMAs the article points out, a "fair" P/E is always relative to other economic conditions, and so no concrete number will be right for all markets.
However, the market has a growth bias; it's more likely that the market will rise, rather than fall.
So, if P/E ratios ever get back to 8, the overall economy will surely be doing horribly, but it would also be a pretty good bet that if one bought blue-chip stocks, their value would eventually rise substantially, as the economy improved.