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« Asset Allocation Gets Notice | Main | Payroll Employment Time »

April 03, 2007



Why so much noise for a model that is useless as it is comparing two assets that are overvalued. US bonds are too expensive considering that us economy resembles to that of an emerging market and us stocks are at the peak of a cycle with unsustainable earnings. Besides one should compare dividend yields vs. yield bonds, not earnings. That model is senseless.


I believe CXO compares earnings yield with the inflation rate, no adjustment to earnings yield.

Bill a.k.a. NO DooDahs!

A word or several about "real" interest rates. Let's not confuse the cause with the effect. Inflation is a monetary phenomenon, and price index increases are *an* effect of inflation, and not "inflation." Of course, now we need to spend hours debating what exactly is "money." Easy Al doesn't even know. Is credit "money?" Well, if I'm competing in the market to buy a house, it sure the frick is. Does (did!) M3 capture all credit? I don't think so. Don't forget that money supply, whatever "money" is, is increasingly global.

I do think it's possible that the Fed model might be improved if interest rates were calculated relative to something that proxied for the negative opportunity cost of holding fiat currency, but I will argue about what that proxy should be.


Also, I haven't checked the algebra on this, but if the adjustment is made to both earnings yield and interest rates, does it become irrelevant?


RB -

Thanks for your usual thoughtful comments and the links. I invite readers to check out the various alternative models. I have tried to write -- in general terms -- why I prefer the simple approach posted here to some of the alternatives. If you apply the criteria I have suggested, you will see some problems.

CXO has several different approaches. Their research is highly professional, and the supporting evidence is generally sound. It is a good source for finding various viewpoints on the Fed Model.

A drawback of a blog like this one is that any research review requires many hours of preparation and careful writing. We do not charge in blindly. We expect to have our errors pointed out.

To summarize, I am not going to do a "partial" review of individual models. If readers have a favorite alternative to the Fed Model, I might put it on the (growing) list of future topics.

Thanks again.



Thanks to Barry for stopping by and commenting, and to those helping to respond. Barry's point seemed to deserve more space, so I featured it in tonight's post.

Even though the conclusion is favorable for the Fed Model, I agree with RW that this is more of a strategic tool.


Based on this approach using standard deviation bands, I do not see the Fed model failing in 1982 and which also indicates that stocks are currently significantly undervalued.

Based on a model using real earnings yield using the Fed's favorite core inflation number, the market today is slightly overvalued.

Based on cyclically adjusted measures, the market is currently 35% overvalued.

At this point, the real experts should step in.


Gian Gravina once famously remarked that "[T]he bore deprives you of solitude without offering companionship." The online equivalent being one who intrudes upon a conversation and is neither constructive nor civil.

I'm sure the host here will have something substantive and useful to offer and, should a real conversation occur we may all profit.

From my own perspective the Fed model is less a predictor (even though it does use forward-looking data) and more of a stance, a "what has greater likelihood of profit now" matter, at least when it comes to allocation between stocks and bonds (the investment universe is much larger than that of course so further work will need to be done naturally).

Nova Law

Barry, interest rates are not historically very low, not when you adjust for the current rate of inflation. 10 years ago interest rates were higher because inflation was higher.

Oh wait, let me do your rejoinder for you to save you time - "inflation is higher now because the Administration is lying about the "real" inflation number, while 10 years ago they did no such thing."

That Damn Bush. He's responsible for everything bad in the world, including that bad case of athlete's foot I got last week.

Barry Ritholtz

As I specifically quoted in the post, according to the Fed Model, in 1981 stocks with depressed earnings and sky high interest rates were crazy expensive -- just as the greatest bull market in US history began.

That is a VERY significant flaw in the Fed Model. Missing what may very well be the greatest buying opportunity in a generation raises some very serious questions about any model that proclaims to be able to determine valuation.

In the pre-1982 version, interest rates were inordinately high and profits inordinately low, thus stocks looked extremely expensive. A bit of mean reversion on both of those, and stock valuations suddenly became much more reasonable.

Today, we have the exact opposite -- the 10-year interest rate level is still historically very low, while profits are very high. A little mean reversion on each and sudddenly stocks will look pricey.

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