Is the market cheap or expensive?

Is the market cheap or expensive?

Recently, our friends at AMP capital released a note suggesting the market might not be expensive.

In the 28 April article entitled “Where are we in the investment cycle” the author writes;

“So the big question is: are we at or near “exhaustion” for the cyclical bull market in shares? The best way to look at this is to assess market valuation, economic growth and inflation pressures, monetary conditions and investor sentiment.”

Share market valuations are mostly okay. Sure, measured in isolation against their own history shares are no longer dirt cheap. In fact, forward price to earnings multiples in the US and Australia are above long term averages. [see Figure 1.]

However, once the gap between share market earnings yields and bond yields is allowed for, shares still look cheap. [Figure 2.]

To suggest that shares might still be cheap, AMP have cited (see Figure 2.) a derivative of a model known as the “Fed Model”. By comparing the stock market’s one-year forward earnings yield (E/P) to the yield on 10-year Treasury notes, the Fed Model states that bond and stock markets are in equilibrium, and fairly valued, when the earnings yield equals the bond yield.

According to those who attribute some predictive power to the Fed Model, if the equity earnings yield is above the government bond yield, investors would benefit by shifting funds from bonds to equities.

By way of background, the Fed Model was so named by Ed Yardeni, at Deutsche Morgan Grenfell, based on a statement made by the US Federal Reserve in the Humphrey-Hawkins report of July 22, 1997 that warned:

“…changes in this ratio [P/E of the S&P 500 index] have often been inversely related to changes in the long-term Treasury yields, but this year’s stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown.”

In other words, in 1997, Treasury yields were higher than the equity earnings yield. According to the Fed Model, investors would benefit in 1997 by shifting funds from equities to bonds. In July 1997 the S&P500 traded at 930 points. By July of 1999 however the S&P had traded at more than 1400 points – a 50 per cent return over 2 years. This compares to a total return for US10Yr Treasuries of 7 per cent[1].

Interesting.

According to Clifford S. Asness from AQR Capital Management, LLC, in his 2002 Paper entitled, Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns;

“The “Fed Model” has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market’s earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional methods evaluate the stock market purely on its own without regard to the level of interest rates. My goal is to examine the theoretical soundness, and empirical power for forecasting stock returns, of both the “Fed Model” and the “Traditional Model”. The logic most often cited in support of the Fed Model is that stocks should yield less and cost more when bond yields are low, as stocks and bonds are competing assets. Unfortunately, this reasoning compares a real number to a nominal number, ignoring the fact that over the long-term companies’ nominal earnings should, and generally do, move in tandem with inflation. In other words, while it is a very popular metric, there are serious theoretical flaws in the Fed Model. Empirical results support this conclusion. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates. I also examine the usefulness of the Fed Model for explaining how investors set stock market P/Es. That is, does the market contemporaneously set P/Es higher when interest rates are lower? Note the difference between testing whether the Fed Model makes economic sense, and thus forecasts future long-term returns, versus testing whether it explains how investors set current P/Es. If investors consistently confuse the real and nominal, high P/Es will indeed be contemporaneously explained by low nominal interest rates, but these high P/Es lead to low future returns regardless. I confirm that investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower and vice versa. In addition, I show that this relationship is somewhat more complicated than described by the simple Fed Model, varying systematically with perceptions of long-term stock and bond market risk. This addition of perceived risk to the Fed Model also fully explains the previously puzzling fact that stocks “out yielded” bonds for the first half of the 20th century, but have “under yielded” bonds for the last 40 years. Finally, I note that as of the writing of this paper, the stock market’s P/E (based on trend earnings) is still very high versus history. A major underpinning of bullish pundits’ defense of this high valuation is the Fed Model I discredit. Sadly, the Fed Model perhaps offers a contemporaneous explanation of why P/Es are high, but no true solace for long-term investors.”

On page four of the paper Asness observes: “While the Fed Model fails as a predictive tool for future long-term stock returns, I find more success for it as a descriptive tool for how investors choose to set E/Ps. Applying a relationship studied in Bernstein [1997, 2002] and Asness [2000] I show that investors do in fact set current E/Ps as a direct function of nominal interest rates. However, the relationship is subtle, as it must be conditioned on the perceived volatility of stocks and bonds. Without conditioning on perceived volatility, the simple Fed Model is a failure, even for only description, over 1926-2001. On the other hand, with conditioning on volatility, the Fed Model cleanly explains the puzzle of why the relative yield on stocks and bonds has varied so greatly over the last century.”

“Note the seeming contradiction, and potential confusion, in my assertions. I first argue that the Fed Model is theoretically flawed amd, consistent with this, is a poor forecaster of of long-term future stock returns. I then turn around and argue that the Fed Model, if properly adjusted for changing perceptions of stock and bond market risk, is a powerful descriptive tool for how investors actually set stock market P/Es….I show that investors do contemporaneously set P/Es based on nominal interest rates (the Fed Model as explanatory tool). However, I argue that they most probably do so in error, largely because the consistently confuse the real and the nominal…Because they do so in error it is not a contradiction but follows quite naturally that the Fed Model is a poor forecaster of stock returns.”

In essence, this suggests that AMP’s view – that the market is not expensive and might actually be reasonably cheap – could be completely wrong.

We believe it is essential when valuing companies and markets, to do so without reference to price. That means removing all inputs that are price related. Price/Earnings ratios, earnings yields and PEG (Price earnings growth) ratios, form no part of the valuation equation. Whether a business is listed or unlisted it can and should be valued without reference to the stock market.

Our own valuation approach suggests the market is in fact about ten per cent overpriced. In other words it IS expensive. What is important to note is that in the past, a ten per cent overpricing by the market has not preceded an imminent correction. The market has been more expensive in the past than it is now and has remained expensive for longer periods than it has recently. Having said that, the fact remains that periods of exuberance are always followed by periods of despondency.

[1] Mark Todd, MD NAB Fixed Interest

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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