Investing for 2007: A Review of Valuation Issues

In preparing for this year’s market review, we were rather surprised to see how little had changed in a year.  The same people were arguing over market sentiment and pointing at the same indicators.  Those predicting the collapse of the housing market and the consumer were still doing so, moving the calendar forward a year in their recession predictions.

The old material is so good and so relevant that it provides a great starting point.  Let’s take the observations one at a time.

  1. Many analysts discuss valuation in terms of trailing PE ratios.  We can count on Barry Ritholtz to present this market perspective in the most effective possible terms.  Take a look at this year-old chart via Mike Panzer.  We will probably get an updated version from Barry in the next week or so, but this is the best we have for now.
  2. We thought this chart was a good example of what we typically see in the paper and on financial television.  We analyzed the key problems — ignoring forward earnings and also interest rates.
  3. Finally, we compared the backward-looking approach to one that employed both forward earnings and interest rates — the Fed model.

This series will extend the use of the Fed model, which has served as a lightning rod for criticism.  Unlike many who have read only article titles or abstracts (The Fed Model Does not Work –yada yada) we have actually reviewed and analyzed the criticisms.  We have a few tweaks in mind, also, but still see great value in starting with interest rates and forward earnings.  Economists made great progress by starting with the assumption of "a rational man."  Perhaps we can do the same with a simple model that encompasses the two most important concepts.

Here’s something to watch for during this forecasting season.  Many, many commentators will talk about PE ratios and make historical comparisons.  If that is all they do, you can just ignore them.  Anyone who does not make a comparison to interest rates or earnings prospects either does not get it or is selling something you do not wish to buy.

Some will comment by saying that "interest rates are low."  They are doing a back-door Fed model.  It is a seat-of-the pants method for doing what the model does in a testable quantitative fashion.

Some will comment that "earnings estimates are too high."  They are also doing a back-door Fed model and asserting that their own personal macro view of earnings is better than the aggregated view of company analysts.  Maybe so, maybe not.

Readers who follow our entire series can judge for themselves the value of the Fed Model as an approach.

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