Perhaps the most common investment question is "What do you think of the market?"
- To an informed group of market analysts, the question invites intellectual discussion and is very difficult to answer succinctly.
- In casual conversation with friends, however, the question can be like an overused pickup line at a cocktail party.
Expectations about the future are extremely important in the determination of security prices. Even if you are a firm believer in the efficient market hypothesis, it is difficult to make informed investment decisions with complete disregard for:
- the current level of the popular indexes or
- the prospects for the economy.
The Greenspan Model
The Greenspan Model is a heuristic many people use as
one means of estimating the over- or under- valuation of the broad market. The model is simple: just subtract the S&P 500 earnings yield from the current yield on a 10-year Treasury security.
Greenspan market value = 10-year Treasury yield - S&P 500 earnings yield
When the result is positive, the market is overvalued.
When it is negative, the market is undervalued.
According to the Greenspan model, the broad stock market was overvalued for the entire decade of the 1990s. There were buying opportunity in 2003 and 2004, but in the mid-2005 stocks were starting to get pricey again.
As with historical PE ratios or earnings yield figures, the Greenspan model offers some historical indication of the
reasonableness of the current level of the market, given estimated earnings and the interest rate environment.
