On the other side are market observers, such as Jeremy Siegel, who make the case that adjustments need to be made to the Shiller CAPE 10, due to changes in accounting rules (FAS 142) and historically lower dividend payouts, for it to be an accurate metric for market value. With those adjustments made, the Shiller CAPE 10 is about at its average since 1960.
There are still others who believe that stocks aren’t highly valued, let alone overvalued, by using what has become known as the Fed Model. They compare the earnings yield (E/P) to the yield on the 10-year Treasury to determine fair value.
Dissecting the Fed Model
In 1997, in his monetary policy report to Congress, then Federal Reserve Chairman Alan Greenspan indicated that changes in the ratio of prices in the S&P 500 to consensus estimates of earnings during the coming 12 months have often been inversely related to changes in long-term Treasury yields. Following this report, Edward Yardeni speculated the Fed was using a model to determine if the market was fairly valued (how attractively stocks were priced relative to bonds). The model, despite no acknowledgement from the Fed, became known as the Fed Model.
Stocks ≠ Bonds
This is a critical point that seems to be lost on many investors. The end result is that those who believe low interest rates justify a high valuation for stocks, without that high valuation ever impacting expected returns, are likely to be disappointed. When P/E ratios are high, expected returns are low, and vice versa, regardless of the level of interest rates.
Real vs. Nominal
To keep our example simple we’ll assume that there’s no risk premium in the yield on nominal bonds for unexpected inflation and there’s no liquidity premium in the yield on TIPS (Treasury Inflation-Protected Securities). Let’s also assume the real yield on 10-year TIPS is 2% (wouldn’t that be nice), and the expected long-term rate of inflation is 3%. Thus, the 10-year Treasury bond yield would be 5% and the fair value for stocks would be at a P/E of 20. Now, lower the 3% assumption for inflation to 2%. This would result in yields on the 10-year Treasury bond falling from 5% to 4%, causing the fair value P/E to rise to 25. But, since inflation does not impact the real rate of return demanded by equity investors, it shouldn’t impact valuations. In addition, as stated above, over the long term there is a strong relationship between nominal earnings growth and inflation. In this case, a long-term expected inflation rate of 2%, instead of 3%, would be expected to lower the growth of nominal earnings by 1%, but have no impact on real earnings growth (the only kind that matters).
Because the real return on bonds is impacted by inflation while real earnings growth is not, the Fed Model measures a number that is impacted by inflation against a number that isn’t, causing the money illusion.
This too, however, doesn’t make sense. A slower rate of real economic growth means a slower rate of real growth in corporate earnings. Thus, while competition from lower interest rates is reduced, future earnings will be as well.
Because corporate earnings have grown in line with nominal GNP growth, a 1% lower long-term growth rate in GNP would lead to 1% lower expected growth in corporate earnings. So the “benefit” of falling interest rates would be offset by the equivalent fall in future expected earnings. The reverse would be true if a stronger economy caused a rise in real interest rates. The negative effect of a higher rate of interest would be offset by a faster expected growth in earnings. The bottom line is there is no reason to believe stock valuations should change if the real return demanded by investors hasn’t changed.
The Bottom Line
Thus, it’s possible that higher interest rates, if caused by a stronger economy and not higher inflation, could actually justify higher valuations for stocks. The Fed Model, however, would suggest that higher interest rates indicate that stocks are less attractive. And the reverse would be true if a weaker economy led to lower real interest rates.
Even smart people make mistakes, usually out of ignorance. You, however, now have the tools to see through the money illusion.