Yesterday' we took note of the Bloomberg story, Cheapest Stocks in Two Decades Signal Bull Market, which quoted several large and successful fund managers. This story stimulated a post from Barry Ritholtz at the Big Picture, where he said that the Bloomberg story was based upon the “flawed Fed Model.”
This is a timely occasion to summarize our series on valuation, including some of the prominent criticisms.
Our readers should understand that like them, we are consumers of models. My own model-developing days ended about ten years ago. (At least for stocks. I still dabble in "recreational" modeling.) Since then I have tested and reviewed many suggested stock market models, and provided feedback for my partner, Vince.
We did not develop the Fed Model, nor have we published any academic reviews. We have no allegiance to those who created it. We are perfectly willing to abandon it in favor of some other approach if we could find one that was better.
Some have suggested that the Fed Model is used by bullish pundits and managers. We find the causation in this statement to be backwards. The Fed Model helped us and our investors to avoid losses in the bubble era. Methods precede conclusions, at least for those who have intellectual integrity.
Briefly put, we are just like the average reader seeking methods to improve investment performance. The only difference is that we bring to the job more than thirty years of experience in developing and evaluating models of all types. Also, unlike many of those citing critics of the Fed Model, we have actually read the papers and articles involved.
Our work at "A Dash" is not intended as an article in an economic journal, so we are not going to initiate some scholarly debate that few in our audience will understand. Our conclusions and reasons are simply and clearly stated. We intend our work to benefit individual investors and some thoughtful traders.
As background, let us say what it is that we like most about the Fed Model.
- It captures the right level of complexity. It is much, much better than valuation models that look at trailing earnings and/or ignore interest rates. It is superior to models that add more variables without much more explanatory power.
- The model is based upon a plausible process. The investor in a particular stock looks at expected earnings for the company and compares that return with the return of a bond. The summation of millions of such decisions for the 500 S&P stocks is that the equity market as a whole has an expected asset return of bonds.
No other approach shares these virtues. Anyone with experience in building systems and models will appreciate why these elements are important.
First, from Barry Ritholtz's column we have the following.
The Fed Model is Imperfect. This criticism comes from two sources:
- Those who have never developed a model. If they had, they would realize that all models are imperfect. If you read such a criticism, you might ask whether the critic can do any better?
- Those who are trying to write a journal article or book. The relevant knowledge quickly gets to the point of practical value and beyond. A good test is to ask whether a proposed "tweak" to a model really corresponds to the reality of the investment process.
The Fed Model "double counts" interest rates. The idea is that low interest rates are good for corporate profits and also suggest that stock P/E ratios should be higher.
We do not see the point. The investor has a choice between two assets. If interest rates rise, the gap narrows. Maybe the narrowing occurs more quickly if rates rise. So what?
The Fed Model "assumes" facts about earnings and interest rates. Barry writes as follows:
The biggest problem with the so-called Fed model is that its built on two assumptions: 1) That profits will stay high, despite being a cyclical peak and decellerating; and 2) that interest rates will stay low.
This is quite incorrect. The model makes no assumptions. It takes current data about earnings projections and interest rates. If earnings fall or interest rates rise, those following the model should adjust their behavior.
It is Barry who is making the assumption. He believes that earnings are at a cyclical peak, a question that is very much in doubt. He believes that interest rates are going higher. Unlike the model, which is based upon current (and forward-looking) data, Barry is saying that he knows better than all of the analysts doing earnings estimates and better than the deep and liquid bond market. Wow!
One might wish to note that earnings estimates have beaten the published expectation for several consecutive years, not missing a quarter. In fact, the standard Wall Street line is that companies have attempted to lower the bar so that they can beat estimates. If this is true, why should we believe that the sum of these forward estimates is overstated?
Valuation models are poor timing tools. We agree! We see valuation as a gauge of long-term sentiment. Sentiment was euphoric in the bubble era, clearly identified by the model. The current era shows that sentiment is very negative. Investors have clearly accepted many of the bearish arguments about recession chances, housing problems, oil prices, the Fed, and a variety of misleading charts and anecdotal evidence.
The current valuation gap is useful in showing how much negativity is already reflected in the market. The risks to earnings and interest rates are not the private knowledge of bloggers and bearish pundits. Their widespread public recognition has had a major impact on mainstream thinking. What if things are not as bad as they suggest? The Fed Model shows what can happen in a return to normalcy -- not roaring good times, just normalcy.
A valuation model imposes discipline on one's thinking. It provides a way of measuring negative effects. It is not only the Fed Model. Various other approaches that include forward earnings and interest rates give similar results. Without the discipline of a quantitative model, one is free to speculate about each data point. This is useful for those writing a daily blog, who want freedom to cherry-pick evidence. It is less useful for understanding what is already "baked in" the market.
The Wall Street Journal Article
Barry cites a breezy two-year old article where Jonathan Clements interviewed some Fed Model critics. Let us consider those criticisms.
The Fed Model uses operating earnings, not actual earnings. Right! And correct for modeling! Investors making individual stock decisions look forward. They tend to dismiss one-time events. Those paying attention have noted that the serial "one-time" charges of the 2000 era are less prevalent. It is done on a stock-by-stock basis, and the result is a market of stocks.
Bond returns are known and stock returns are not. This statement is not correct if the investor plans to rebalance asset allocations every year or two, as the model changes. It is possible to have major capital losses in bonds if interest rates increase. Meanwhile, the return from stocks has more volatility, but also more upside. This occurs both with higher inflation or with better than forecast economic conditions. When Ed Yardeni studied this problem in 2003, he chose not to include a special risk premium for stocks. It was not that there was no risk -- just that the risk/reward calculation did not favor bonds. The available data supports his conclusion. One might also note that the earnings return from stocks was dramatically under-estimated at the time Clements wrote the article. Maybe it is time for the critics to freshen their data sets.
Summary of Our Work
We believe that an individual investor could spend some time wisely by reviewing our rather extensive material on this topic.
We showed the Fed Model in three time frames. Look at the data and make your own decision.
We showed why valuation models revealed long-term sentiment, and the factors behind the current cycle of negativity.
We showed the importance of forward earnings. Many of the critics of the model do not really use forward earnings. They use some assumed trend, an approach that is frequently erroneous.
We discussed the merits of "tweaking models" like this one, and the pitfalls in trying to over-fit data to recent conditions.
We showed how a leading analyst from a bulge-bracket firm could get it completely wrong by trying to tweak the Fed model.
Finally, we summarized what this all means for the current market. Understanding this topic shows why the current market is so resilient to negative factors, and why there is so much upside potential. It is the kindling for what Gary D. Smith has called the "mother of all short squeezes."
There are some other specific criticisms of the Fed Model, including our own. We shall revisit the topic for these questions, but this summary article captures the key points for an investor who is alert to opportunity.