Equity Market Valuation Are we close to the bottom? Guy Lion 11/25/2008

The Fed Model The Fed has tracked market valuation by comparing the Earnings Yield (E/P or the inverse of the P/E) to the 10 year Treasury bill. Edward Yardeni stated this model makes good sense because it is a short cut to a more complete valuation model: Earnings/(Risk free rate + Risk Premium – Earnings growth rate). According to Yardeni, the risk premium and the growth rate have historically been not that far apart. Netting them out, you are left with the Fed model. By dividing the Earnings yield by the 10 yr Treasury yield, you can figure if the market is overvalued or undervalued. Let’s say the Earnings Yield is 5% and the 10 yr Treasury is 4%. In such a situation, the market would be -20% undervalued. [1/(5%/4%)]-1 = - 0.2

The Fed has tracked market valuation by comparing the Earnings Yield (E/P or the inverse of the P/E) to the 10 year Treasury bill.

Edward Yardeni stated this model makes good sense because it is a short cut to a more complete valuation model:

Earnings/(Risk free rate + Risk Premium – Earnings growth rate).

According to Yardeni, the risk premium and the growth rate have historically been not that far apart. Netting them out, you are left with the Fed model.

By dividing the Earnings yield by the 10 yr Treasury yield, you can figure if the market is overvalued or undervalued. Let’s say the Earnings Yield is 5% and the 10 yr Treasury is 4%. In such a situation, the market would be -20% undervalued.

[1/(5%/4%)]-1 = - 0.2

Fed Model Valuation History The values I computed are higher than usual because I relied on 4 quarter trailing earnings to calculate earnings yield. For the value on 11/25/2008 I included a 4th quarter earning estimates equal to the 3d quarter figure. Changing this single quarter estimate downward has little implication on the findings.

Fed Model narrative A value above 0% suggests the market is overvalued as the E/P > 10 year Treas. yield by the mentioned amount and vice versa. The average since 1988 is for the market to be 27% overvalued. This is also a function of my using trailing earnings instead of forecasted ones that would have brought this average figure a bit closer to 0%. The Fed Model does a good job of picking up the stock Bubble in the second half of the 90s and the ensuing Bear market in the early 00s. It also suggests the stock market was not overvalued since the aftermath of the dot.com Bubble crashing in the early 00s. It also shows how brutal the current Bear market has become. As of 11/25/2008, the S&P 500 was -40% undervalued by this parameter. This is the deepest market discount since the onset of this data (Standard & Poors did not disclose the S&P 500 earnings prior to 1988).

A value above 0% suggests the market is overvalued as the E/P > 10 year Treas. yield by the mentioned amount and vice versa.

The average since 1988 is for the market to be 27% overvalued. This is also a function of my using trailing earnings instead of forecasted ones that would have brought this average figure a bit closer to 0%.

The Fed Model does a good job of picking up the stock Bubble in the second half of the 90s and the ensuing Bear market in the early 00s.

It also suggests the stock market was not overvalued since the aftermath of the dot.com Bubble crashing in the early 00s.

It also shows how brutal the current Bear market has become. As of 11/25/2008, the S&P 500 was -40% undervalued by this parameter. This is the deepest market discount since the onset of this data (Standard & Poors did not disclose the S&P 500 earnings prior to 1988).

Risk Premium is very high Within his Earnings/(Risk free rate + Risk Premium – Growth rate) model framework, Yardeni defines the Risk Premium as the yield on single A rated securities – 10 Year Treasury yield. Time series of A rated yield have been discontinued. So, I have constructed single A yield by doing: (2/3)Baa yield + (1/3)Aaa yield. Even if this method is not exact, it would have little implication on the findings-the current risk premium is very very high.

Market Cap/GDP Here we are looking at the total market cap of domestic corporations vs the GDP going back to 1987. As of 11/25/2008, the ratio is a very low 63%. It was lower near 50% during the late 80s (crash of 87). But, it is far below the average around 100% since 1987.

Conclusion In unprecedented times, common market metrics may have less traction. Nevertheless, we can readily observe this Bear market is huge. And, has put a nasty cap on the “lost decade.” Stocks may become even cheaper. But, it would not be surprising when the upcoming Obama Administration implements a $500 billion infrastructure investment package, the stock market could mend its ways…

In unprecedented times, common market metrics may have less traction.

Nevertheless, we can readily observe this Bear market is huge. And, has put a nasty cap on the “lost decade.”

Stocks may become even cheaper. But, it would not be surprising when the upcoming Obama Administration implements a $500 billion infrastructure investment package, the stock market could mend its ways…