US Stock Value
The data shown below are the results of a SIMPLE
Fed Stock Model.
As far as I'm concerned, this model is useful only as a benchmark to
show relative valuation levels. That is, since 1994 the valuation
levels, based on forecasted operating earnings, have ranged from a
high of 70% overvalued during 1999Q4 to a low of 77% undervalued
during 2011Q3.
The biggest problem with this model is that it relies on reported
and forecasted earnings. Reported earnings are generally not revised
appreciably, but the BIG problem is that it is reasonably well known that forecasted earnings are
fairly naive estimates based on the hope that everything will
improve tomorrow. That means that if everything improves tomorrow, then the model will function as designed
and vice versa.
On December 30, 2011 the S&P 500 closed at $1,257.60
And the Yield on the Ten Year Treasury Note was 1.89%
Based on S&P forecasted operating earnings,
US Large Cap Stocks were 77% under-valued relative to the Ten Year
Treasury Note.
OR,
Based on forecasted reported earnings,
US Large Cap Stock were 76% under-valued relative to the Ten Year
Treasury Note.
OR,
Based on current reported earnings,
US Large Cap Stock were 74% under-valued relative to the Ten Year
Treasury Note.
If the Yield on the Ten Year Treasury Note were to rise by 6.49%,
AND IF
earnings remained constant,
THEN
based on forecasted operating earnings,
stocks would be fairly-valued.
For more go to Market Timing
How can the information shown above be used?
Frequently analysts, columnists, commentators, and others will refer to the Fed’s stock valuation model when comparing relative stock and bond valuation levels. The Fed's model was in a report Alan Greenspan submitted to the FOMC in December 1996 when he spoke of irrational exuberance. Shortly thereafter the model gained widespread acceptance as a stock and bond valuation tool. The values shown above were computed using the Fed Stock Valuation Model and Standard & Poor's earning's forecasts. These free forecasts are on their website and are generally updated weekly. This report will generally be updated on the weekend following the market's close each Friday.
There is a comprehensive explanation of how the Fed Stock Model can be used to determine Stock and Bond proportions in a portfolio on this website. Briefly, if stocks are fairly valued relative to bonds, then the Fed Stock Model suggests an equal portion of stocks and bonds should be held in a portfolio. If stocks are undervalued, then the model suggests a larger portion of stocks should be held and vice versa. Most analysts use forecasted operating earnings when comparing stock and bond relative valuation levels. I have added a valuation level based on forecasted reported earnings to this page so you may choose the more appropriate method yourself. Generally speaking, operating earnings are earnings from operations without "one time" charges such as plant closings etc. Go to Standard and Poor's website for a comprehensive explanation of reported and operating earnings. Note that analysts frequently change their opinions about future earnings, primarily because they're frequently wrong. Pay some money and take some chances. Wheeee!
I have also added a valuation level based on current reported earnings. This value is given for reference only since most analysts agree that you pay for future earnings when you buy stocks.
The Fed Model has come under attack recently and some critics are questioning the validity of its results. I disagree with the critics but welcome any intelligent critical comments. Recognize that many stocks in any stock market will unexpectedly out-perform and many others will unexpectedly under-perform. The same can be said for the entire market: At times it will be incredibly over-valued or under-valued; several months or years later it may be even more over-valued or under-valued. Recognize that as a fact of investment life and try to be emotionally and financially prepared to deal with it.