Fed Model of Stock Market Valuation

Fed Model of Stock Market Valuation

Greenspan's testimony in his semiannual address to Congress in 1997 suggested that the central bank regarded the stock market as overvalued whenever this earnings yield fell below the bond rate and undervalued whenever the reverse occurred.

The basic idea behind this Fed model is that bonds are the chief alternative for stocks in investors' portfolio.

• The return on a bond can be termed the interest yield.
• The return on stocks is termed the earnings yield.
• When the interest yield rises above the earnings yield, stock prices fall because investors shift their portfolio from stocks to bonds.
• On the other hand, when the interest yield falls below the stock yield, investors move into stocks, boosting their price.

Institutions have been using the relation between interest yields and stock yields to determine their asset allocations for many years.

What is unique about the Fed model is that it directly compares these two yields rather than just noting a correlation between them.

The Fed model appears to have worked fairly well since 1970. When interest rates fell, stocks rallied to bring the earnings yield down, and the opposite occurred when interest rates rose.

What is surprising is that this relation holds despite the fact that stocks and bonds are very different assets. The reason why the Fed model works is that the market rates these two advantages as approximately of equal value when inflation is an important factor.

There is no question that both bonds and stocks do badly when inflation increases.

• Bond prices fell in the late 1960s and 1970s because rising inflation forced interst rates up to offset the depreciating value of money.
• Inflation was accompanied by an increase in energy costs, poor productivity growth and poor monetary policy. Therefore, inflation depresses corporate profits and real stock returns.
• Finally, inflation increases uncertainty and raises the threat of central bank tightening of money policy to halt rising consumer prices. This is also negative for stocks.

Falling interest rates boosted both stock and bond prices as economic growth increased. The 1980s amd 1990s were good decades for both stocks and bonds as inflation declined from its record high levels.

However, both history and theory suggest that the Fed model breaks down when inflation is very low or when consumer prices are stagnant and deflation threatens. In such circumstances, bonds (especially risk-free government bonds) will do very well, but stocks returns will be ambiguous.

Given that interest rates and inflation have now shrunk to their lowest level in four decades, stock investors should be wary of using the Fed model.

• Stocks still will welcome any Fed reduction in interest rates, but declines in long-term government bond rates often signal strong deflationary or recessionary forces. It will be harder under these circumstances for firms to raise their output prices to cover costs. Deflation undermines firms' pricing power, and this cuts into profit margins.
• Moreover, because it is extremely difficult for firms to negotiate nominal wage cuts, deflation increases real wage costs and reduces profits. Thus nominal assets such as bonds will shine under deflation, whereas real assets often suffer.

Unless inflation heads upward again, it is unlikely that the tight correlation experienced over the past two decades between these two yields will continue.

• In a low-inflation world, pricing power and earnings potential will dominate stock valuations, whereas bonds will be valued for their ability to hedge deflationary risk.
• Rising and falling interest rates still will be very important determinants of stock prices in the very short run but long-run patterns are apt to diverge as investors recognize the fundamental differences in the assets.

Additional notes:
Present market PE of KLSE is around 15, giving an earnings yield of 6.7%.
The interest rate is about 3%.