Fed Model Update

Periodically, we update our version of the so-called “Fed Model” to provide a picture of how current US stock market valuation compares to Treasury yields from a historical perspective.  Traditionally, the Fed Model takes the trailing twelve month P/E ratio for the S&P 500, inverts it to get what’s known as the “earnings yield” then takes the ratio of the earnings yield to the yield for the 10-year US Treasury bond.  Theoretically, the higher the ratio, the more undervalued the market is and vice versa.  There have been many justifiable criticisms of the traditional Fed Model, many due to the fact that the traditional Fed Model has been an imperfect predictor of future stock market out and under performance.  We think some of this has to do with the traditional volatility of the trailing twelve month P/E ratio, which can jiggle violently during times of major movements in price and underlying earnings, especially when earnings completely fall out of bed.

To combat this issue, we substitute Shiller’s 10-year CAPE P/E for the trailing twelve month ratio as the “E” in the longer-term version is much more stable.  The longer term chart for this indicator follows:

As you can see, using +/- 1 standard deviation bands as a guide, the model has performed reasonably well in signaling severe under and over valuation turning points, especially on the undervaluation side.  A move above the range in early 1962 (undervaluation) presaged a strong move higher in markets for the next several years.  Similarly, the move above the standard deviation range during the market lows of 1974 proved to be a decent point for what would become a bull market rally lasting until 2000, which is where extreme overvaluation levels were reached (though in fairness it took until 1982 for the bull market to begin in earnest).  The model again signaled extreme undervaluation levels in the wake of the financial crisis in late 2008.  Since that time, the model has remained in severe undervaluation territory, primarily due to the fact that 10-year Treasury yields remain so low.  During that time, US markets have tripled off the lows on a nominal return basis and performed even better when dividends are taken into account.  

As of now, owing to the continued low bond yields, the model remains in undervalued territory, despite the fact that long-term CAPE P/E ratio is reaching very extended levels.  Many observers would argue that the model is “broken” due to the outsized influence of extraordinary Federal Reserve policy on long-term interest rates.  Over the past several years, however, markets have continued to move higher validating the signal, even though it’s been “distorted.”  

The signal could move out of undervalued territory one of several ways.  A strong spike in Treasury yields would of course push the ratio down all things being equal.  Or, for better or worse, the market could take off to the upside recreating the extreme CAPE valuation bubble scenario observed in 1999 and 2000.  Or, certainly, one could get a strong combination of the two.  

So what happens going forward?  Is this a broken, or meaningless indicator?  Perhaps, using a revised version of the Fed Model could help provide some additional perspective.  Instead of using 10-year Treasuries, we’ve also recreated the Fed Model using long-term investment grade bond yields.  Here is the Fed Model with that adjustment:

This version doesn’t show the same extreme in undervaluation as our “traditional” model, but it’s still near the top of the range observed over the past few decades.  

All things considered, these Fed models add to other pieces of evidence that suggest it may be a mistake to write off the bull market in US stocks just yet.  While US markets are certainly overvalued using the long-term CAPE PEs as a guide, long-term momentum remains comfortably intact, and forward-looking economic models continue to show very low probability for a US recession in coming months.  As we’ve discussed in the past, the most devastating bear markets over the past century have occurred when markets face a devastating combination of extreme overvaluation, deteriorating intermediate to long-term momentum, and a strong deterioration in forward-looking economic indices, such as the Conference Board leading indicators, showing high probabilities of future recession and earnings dislocation.  Right now, two out of three of our indicators are in green territory.  The Fed Models aren’t necessarily the so-called “end all and be all.” But, they’re matching with other indicators, which makes the models hard to ignore, especially since they’ve performed reasonably well as action triggers across several distinct economic periods during the past 50 years.   

Oil Price Decline: Secondary Effects

The financial world has focused much attention on oil markets in recent weeks, and rightfully so.  Brent crude and WTI prices have fallen nearly 50% since summer.  This afternoon, WTI has closed below $58 per barrel for the first time since May 2009.  Obviously, this has enormous impacts on oil industry equities, not to mention the biggest oil-producing countries around the world, at least in the intermediate term.  Levered oil service and extraction plays have seen 50% plus declines in stock prices.  Russia, Venezuela, and a host of other countries have begun to experience severe macroeconomic and market stress due to the price declines.  Meanwhile, the effects on the rapidly expanding shale play in the US and Canada haven’t become fully apparent yet.  It’s safe to say, though, that these price declines will start to severely impact future capital spending in the US and Canadian oil spaces.

Just as importantly, the move in oil is beginning to impact other markets and expectations.  Very quickly, we’ll point out a few instances where the impact of oil’s decline is filtering through global markets.

First, let’s take a look at US high-yield bond markets.  As we pointed out earlier this year, high-yield spreads had narrowed to levels unseen since the pre-2007 crisis days reflecting the general high optimism in global markets and investors search for yield.  Now we’re coming to find out that a solid portion of high-yield issuance in the US was related to the emerging oil boom here.  With oil prices cratering, heavily levered oil-related companies are finding their margin for error in terms of debt service rapidly eroding.  This is beginning to influence overall yields and yield spreads relative to Treasuries.  As you can see below, since oil started declining this past summer, yield spreads relative to Treasuries have jumped approximately 200 basis points.  The absolute yield as represented by the Bloomberg High Yield has jumped by nearly 150 basis points over that time period.  While the spread relative to Treasuries is certainly nowhere near the levels associated with crisis (look at the spike in ‘08/’09), there’s been a quick resetting of expectations in the high yield market in line with oil’s declines.

Next, let’s take a look at market inflation expectations globally (below).  Global central banks now have quite a dilemma on their hands, especially the Federal Reserve and the European Central Bank.  Not too dissimilar to the oil spike in ‘07/’08 sowing confusion among central bankers as to the true path of inflation, central bankers now have some tough decisions to make on future policy as expectations for inflation in the US and Europe have dropped dramatically in line with the collapse in oil.  In the US, for instance, QE3 has been effectively wrapped up, economic data has looked strong, and Federal Reserve officials are talking potential rate hikes by mid-2015.  Meanwhile, 10-Year US Treasury yields are hurtling back towards the 2% level and inflation expectations 5 and 10 years forward are falling back to levels last seen during the crisis.  In Europe, persistent economic weakness has pressured price levels for the past few years; even without the new oil price variable, it’s clear that Europe is treading very close to outright deflation, a strongly negative situation from an economic perspective.  Now with oil falling, inflation expectations have accelerated to the downside, perhaps adding to the urgency of the situation.  Accordingly, Mario Draghi and his colleagues at the ECB are mulling much more forceful action, German reluctance be damned.  How do central bankers incorporate oil’s price influence on overall inflation/deflation?  Remember, in the US pre-crisis, the Fed erred by letting commodity price inflation hold them back from acting more forcefully sooner to counter the growing economic problems.  In this case, does a depressed oil price and headline inflation number keep the Fed from acting quickly enough to address a rapidly improving labor market?  Draghi’s situation is a bit more clear cut—core inflation is on a harrowing downward trajectory too--but these new variables certainly make discussions among numerous stakeholders much more difficult.  

Europe 5-Year, 5-Year EUR Inflation Swap Rate (Future Inflation Expectation)

Source: Bloomberg

Again, we see a situation where action in one market begins exerting significant influence on situations elsewhere, and more rapidly than investors and policymakers are prepared to react.  Oil’s price declines are good for many of the world’s consumers, of course, but they create numerous complications for investors and policymakers across asset classes in many of the developed countries.