Investing for 2007: The Fed Model in Three Time Frames

The Fed Model provides a quantitative analysis of the basic investor decision:  Buy stocks or buy bonds? 
The following chart compares the S&P 500 to "fair value" as determined by the Fed Model, ending in 1998.  It is presented on a log scale to facilitate comparisons over a long historical period.

One can see the basic quality of the overall fit, but there are other important observations.  In the Crash of ’87, for example, one would not have wanted the model to track the S&P in the days preceding the crash.  A valuation model should not be expected to trace the market exactly, but rather provide a warning of anomalies.  The period around the first Gulf War provides a similar illustration.

One might ask why our analysis begins where it does.  The reason is that we do not have a record of forward earnings before 1979.  Anyone reading a Fed Model study that purports to go farther back in history should carefully read the footnotes to see if forward earnings are really being used.

If we had more data, what would or should we use?  We’ll take up this question in our overall review, but regular readers of "A Dash" know that we are extremely skeptical of very old data.  Many big-name investment research firms use data going back to the Great Depression.  One Fed Model critic found trailing earnings for a test going back to 1871, although we cannot imagine why!  A good dividing line might be the invention of market derivatives like stock options and futures and the development of computer-based econometric models.

Let us now take a look at the Fed model including the next period, the Internet/Technology/Stock Market Bubble.  This is a period that is now generally recognized as one that involved excessive stock valuations.  Here is what the model shows:

Fed_model_thru_01A prescriptive model should offer advice; the advice here is similar to the acclaimed work of Robert Shiller.  It shows excessive valuations beginning in 1997 (was it time to sell?) and the big valuation gap at the bubble peak.  Since we believe that is what actually happened, the model is also a good descriptive model.  It accurately identified irrational exuberance and excessive stock valuation.  Despite this performance, some critics alleged that the Fed Model "did not work" because it did not track actual market levels.  One wonders whether these critics just write articles or actually invest.  Most of us would be delighted to have wise counsel that investment in stocks was dangerous.

Anyone who is intrigued by the Fed Model performance from 1979 to 2001, and you should be, might wish to study the current chart.


The key feature of the current chart is the persistent valuation gap.  Stocks became under-valued in 2002 and have remained so for about four years.  It may be helpful to consider "fair value" as a horizontal axis to emphasize the deviations.  Here is a look at the same data using that approach.  This view enables us to focus on the deviations over time.

Sp_over_fv According to the model, we are in the longest sustained period of deviation from calculated fair value in the entire time period.  This intriguing situation deserves further investigation.

Since interest rates and stock prices are known, the only remaining variable in the model is projected earnings.  One could conjecture that the forward estimates are incorrect.  Or one could argue that "things are different this time" and that the relationship between stocks and bonds no longer holds.  Or one could argue that the model is leaving out important considerations that have had a special relevance in the last four years.

The next segment of this series will offer our analysis of this valuation gap.  We will then turn to criticisms of the Fed Model.  In the last of this series of short articles we will ask what stocks might be of special interest in the coming year.

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  • Bill a.k.a. NO DooDahs December 28, 2006  

    Other good dividing lines (besides the derivatives you mentioned) might be
    (1) 1975 – “floating” U.S. dollar, as monetary policy influences the markets.
    (2) The original Bretton Woods agreement.
    (3) Changes in bank investment policy after the Crash.
    Definitely the markets have a different character in different eras. After my work on money policy and stock market post 1980, I personally don’t think a realistic model can GO past the 1975 barrier, and I think there was some adjustment after the currency started “floating.”
    I put “float” in quotes because all fiat currencies fall, but from the perspective of a skydiver, it appears other skydivers are floating …

  • oldprof December 28, 2006  

    Thanks, Bill. Good observations. What would Einstein have thought??

  • RB January 19, 2007  

    Nice post and some perhaps naive questions:
    If you look at the earnings yield in 1979, it wasn’t actually different from the bottom around 1940
    So, why shouldn’t the current period be the top of the range? Also, regardless of financial innovations shouldn’t the market cap be constrained by the GNP over very long time-frames?

  • RB January 19, 2007  

    Looks like the link above got truncated:

  • oldprof January 20, 2007  

    I am familiar with the Gannon article. I promised to deal more extensively with some criticisms to approaches like the Fed model. I will suggest that the model may need another variable. The Gannon analysis leaves out a consideration of interest rates. I find that problematic.
    Thanks for your comment.

  • Scott Teresi February 14, 2007  

    What might a Fed Model say if it were to incorporate global interest rates and an approximation of global earnings yield, rather than being so U.S.-centric? Would this still show stocks as undervalued?

  • oldprof February 14, 2007  

    Good question, Scott.
    The next installment of the series analyzes some limitations on the Fed Model, including the potential to invest in other assets.
    For now, it seems clear that ETF’s have made it easy to invest in world markets. Logic suggests that these asset classes (both foreign stocks and bonds) should be included. There may not be data to do so. More later —
    and thanks again for the question. It is always important to think about omitted variables.

  • Scott Teresi February 14, 2007  

    Thanks, Jeff! I was inspired to ask, by all the talk about the recent S&P Outlook article noting that the yield curve is inverted in the U.S. but not inverted if you use their measurement of global interest rates (GDP-weighted). Is there also an estimate of global earnings? If exact data for these global measurements isn’t available, it seems like rough estimates are. Yahoo reports a P/E even for the Vanguard Emerging Markets fund:
    I’m looking forward to reading your ideas for whether the Fed Model should be changed, and how. It’s great that you’re sharing your years of insight with us!

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