Mark Hulbert: The Fed Model is almost always bullish, which makes it a perfect face for this too-good-to-be-true stock market

Perhaps the bulls’ most widely used argument is that low interest rates justify a higher P/E. On the surface, this has a certain plausibility. If investors see stocks and bonds as competing assets, then they will naturally gravitate to the one with the higher yield. Right now, the S&P 500’s earnings yield (the inverse of the P/E) is 3.6%, nearly three percentage points higher than the 0.7% yield on the 10-year Treasury. TNX, +1.00% TMUBMUSD10Y, 0.720%

If so, then stocks win, hands down. The bulls have even given their argument an official-sounding name: The Fed Model. Doing so represents a considerable amount of hubris on their part, however, since the model is not endorsed by the Federal Reserve. In fact, even its connection to the Fed is tenuous: It traces to a single paragraph in the Federal Reserve’s report to the Congress in 1997 that, more or less in passing, compared the stock market’s earnings yield to the yield on the 10-year Treasury.

The Fed Model’s attraction to the bulls is that it almost always is bullish. For the Fed Model to turn bearish, the S&P 500’s earnings yield would have to get below that of the 10-year Treasury. For that to happen, either the 10-year yield would have to rise above 3.6% or the P/E ratio would have to rise to 143-to-1 — or a combination of both. No wonder the bulls love the Fed Model.

Fed Model’s track record

To measure the Fed Model’s track record, I looked at the stock market on a monthly basis since 1871, courtesy of data from Yale University’s Robert Shiller. I measured the Fed Model’s ability to forecast the stock market’s inflation-adjusted real return over the subsequent 1-, 5- and 10-year periods. In each case I calculated a statistic known as the r-squared, which represents the degree to which one data series (in this case, an indicator such as the Fed Model) predicts or explains another (in this case, the stock market’s subsequent return).

The table below summarizes what I found:

Notice that, regardless of when measuring forecasting ability over the 1-, 10- or 20-year horizons, introducing interest rates into the equation reduces the P/E ratio’s explanatory power.

Questionable premise

You should not be surprised by these results, given that the Fed Model rests on (at best) a questionable theoretical foundation. For starters, there’s no theory that I am aware of which says stocks and bonds should have the same yield. In fact, since stocks are far riskier than bonds, you would expect them not to have similar yields. Without including some assumptions about the equity premium, therefore, we can’t even begin to derive any significance from stocks yielding more than bonds.

Once you try to do that, furthermore, things quickly become more complicated. For example, since nominal corporate profits tend to expand and contract along with inflation, the earnings yield can be seen as a real (inflation-adjusted) number, in contrast to the Treasury’s 10-year yield, which is a nominal number. So comparing these two yields is even more a comparison of apples and oranges. (A good summary of these theoretical points comes from Cliff Asness of AQR Capital Management in the Journal of Portfolio Management.)

The bottom line? Today’s low interest rates don’t support the bulls’ case. That doesn’t mean the bull market is about to come to an end, of course. But it does mean that, if you want to argue that it will continue, you need to base your argument on something besides low interest rates.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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