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« Updating the Market Perspective | Main | Interpreting Comments »

August 21, 2007



Cutten -

You raise some good questions, which I think I have answered in prior articles in this series. Summarizing briefly, extremely low rates may be associated with concern over global deflation or some other event that threatens profits and security. No one believes that the fair value P/E multiple should be 100 if interest rates are 1%.

Determining the correct range to apply a model is a standard research problem. I used to give students a trick question where the correct answer was that the problem was outside the range of data used to develop the model.

Most importantly, if you read the articles on the series you will see that I see the major use of the Fed model has an objective way of spotting extreme investor sentiment.

Thanks for pointing out these concerns. Readers with a serious interest in this topic might enjoy putting "fed model" in our search window and looking at some older articles, including a review of criticisms of the model.



How does the Fed model explain the performance of share prices in environments with extremely low interest rates? I'm thinking of Japan in the ultra-low interest rate environment of the last decade or so, or US share prices in the Great Depression and WWII period.

When long-term interest rates are 0.5%, doesn't this imply a price-earnings ratio of 200 - yet the Nikkei never remotely approach this PE level. Similarly, when US long bond yields were 1.5% in the early 40s, the PE was no way near as high as the Fed model would suggest. Even if you add a risk premium to the bond yield, and assume zero earnings growth, the implied PE was still way above where the markets actually traded.

Unless I have missed something major, then the only conclusion I can reach is that the Fed Model doesn't work. You cannot use a model which would have given horrendeously erroneous predictions for over a decade. And how well did the Fed model work from 2000-2003? Once again, its performance seems unsatisfactory.


As Chris above notes, Hussman has pointed out the similarity with Tobin's results and therefore cannot be easily dismissed. At the simplest level, Hussman's arguments are about mean reversion of earnings yields, something that even diehard bulls like Siegel admit to. Perhaps things are different since 1980 such as lower transaction costs, although the book value related arguments such as Q are quite compelling. With regards to the analysts and their expertise, I have here before me Malkiel's book where he says that in a study by Sandretto and Milkrishnamurthi, analysts earnings estimates were off by an annual average of 31% over a 5-year period. This is also in agreement with the fact that forward PE averages to 11 while trailing reported PE averages ~15 as pointed out by Asness. Analysts estimates were further found to be even less accurate over one-year periods and including for stable earning industries such as utilities. Anecdotally, as senior management once told us -- earnings visibility is very good for one quarter, not so good for two quarters and beyond that, it is just a roll of the dice. Maybe the analysts know something about companies that companies themselves do not.


Nice article. Hussman is obviously a very bright guy, but his dispatches are also obviously marketing material.

I also tend to suspect equations with non-obvious constants. For this reason, I don't understand the appeal of his valuation method versus simpler ones like Andrew Smither's model which is based on Tobin's Q. This method calculates Q as the S&P 500 market cap versus replacement cost as provided by the Fed flow of funds data. Smithers' model seems to avoid most of the criticisms that you make about Hussman's model. It is simple, the data goes back a very long way, and Smithers claims it to be statistically predictive of future returns.

Given that Smithers' and Hussman's models seem to be given the same signal, I'd like to know whether you have looked into Smithers' claims and what your opinion was.


When it comes to investing, many strategies work. In essence, the goal of the Hussman fund is appreciation with minimal drawdowns. As such, he hedges considerably. Nothing wrong with that if that's what you want. As a long-term investor, a well-managed focused portfolio will outperform this strategy since hedging comes with a not so small price tag. Granted there are bigger swings, but as Buffett and others like him have stated, no one ever complains about volatility to the upside.

That said, I actually prefer Hussman's method to dollar-cost averaging into the S&P, as Buffett suggests for the novice investor. The S&P takes some huge swings, and most investors simply do not have the stomach for it. Such people would probably be happier letting Hussman manage their money.

I do believe Hussman is not seeing a number of intuitive points about the Fed Model. As the Old Prof suggests, one of its most useful purposes is guaging investor sentiment. Imo, Hussman is a little bit of a numbers geek. The markets are as much of a psychological game as anything. Further, Hussman repeatedly says he isn't trying to predict anything, which I believe is a mistake. It's been my experience that the more one focuses on the future, the better one becomes at predicting what will come. Case in point, this housing debacle did not catch me or my clients offguard. (Though one wanted to hang onto his housing stocks when I advised him to sell them five months ago. They're now down another 50%.)

David Merkel

Even though his regression fit well, there were two things amiss. One, how many models did he try before he published his model? Did he do a specification search? When I did my model, I did only two passes over the data, and the first was accidental because I didn't have a lengthy corporate yield series. The Moody's series is one of the few that goes back a long way, and Bloomberg did not carry it. I wanted to use BBB corporates from the start, but could not find a series, so I did one pass with Treasuries.

Second, after doing the analysis, the rest of his results rely on an extrapolation from the recent past to the further past. Dr. Hussman is the one who argues that the 80s are unique, but that is a large part of the data that he uses to estimate his backcast. No matter how good the fit, it is not safe to do extrapolations. Too many structural things change over time in capitalist economies.

I say these criticisms hesitantly, because I genuinely admire Dr. Hussman. We even live in the same town, but we have never met. So it goes.

Scott Teresi

As a reader of both your blog and Hussman's Weekly Market Comment, I was really looking forward to your response to Hussman's criticisms of the Fed model over the last few months. Thank you very much!

Even if you use unadjusted Maximum Trailing Earnings as a proxy for Forward Operating Earnings (which, judging by the graphs, seems pretty correlated), rather than Hussman's carefully fitted formula, I imagine you will come to similar conclusions as Hussman about the lack of fit of the Fed Model before 1980.

Maybe we truly can't know if the Fed Model fit back then. Or maybe the investment environment was truly too different for the Fed Model, simple as it is, to work. It seems that both sides of the argument have valid points. Maybe this time things ARE different, but maybe not as different as some think.

Of course we can't be sure one way or the other. Hussman makes many statements which seem at odds with a lot of prevailing notions. I don't have the expertise to dissect some of his more controversial statements, e.g. the trend, not the level, of interest rates correlates (weakly) with future market returns. Or, the Fed is basically irrelevant (it's government spending that affects the monetary environment)...?

I pay attention to Hussman because of his fund's fantastic record at beating the market while maintaining the volatility and downside risk of a bond fund, something very unique for a mutual fund available to a layman like me. (Come to think of it, it would be very useful to see your overall risk-adjusted investment performance at NewArc.)

I'm anxious to see if Hussman will be able to maintain his absolute outperformance until the next bear market, and in an environment where growth possibly dominates over value. I have a feeling the bear market will be further off than he thinks. (I don't know why some people can't imagine that valuations could be permanently higher since the 90's.)


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