Sunday, May 20, 2007

How Much Do Interest Rates Affect the Fair Value of Stocks? / Hussman

the fed model.......why does this remind me always on larry kudlow....?

das fed model wird leider auch bein uns noch viel zu oft zur "kurszielermittlung" der aktienmärkte herangezogen.

.... To estimate fair value, it is crucial to normalize earnings (rather than using “forward operating earnings” without correcting for the level of profit margins or the position of earnings within the economic cycle, as Wall Street seems eager to do here).

But what about interest rates? Sure, S&P 500 earnings are pushing along the very top of the 6% long-term growth trend that has repeatedly connected earnings peaks across economic cycles over the past century, and the S&P 500 currently trades at over 18 times those record earnings. Sure, when earnings have been similarly elevated in the past, the P/E multiple on those “top of channel” earnings has averaged only about 10. Sure, on normalized profit margins, the S&P 500 P/E would be about 25. Sure, profit margins have repeatedly experienced mean-reverting cycles over time. But this time it's different! After all, the current interest rate on the 10-year Treasury bond is a whole 1.4% below the average level of 10-year Treasury yields since 1950, and the year-over-year inflation rate is currently a whole 1.6% below the average inflation rate since 1950. Doesn't this mean that stocks deserve to be valued 60-80% higher than the historical norms?

If you watch CNBC for a few minutes, you'll immediately hear some analyst claim that stocks are cheap because the “forward earnings yield” on the S&P 500 is higher than the 10-year Treasury yield.
The next analyst will just say that “stocks look cheap compared with bonds.” The next will offer some strange convolution of the Fed Model, like “Sure, P/E multiples are above average, but bonds are trading at a P/E of 21.” After a short break from the monotony by some kind of circus clown playing with horns and buzzers, another analyst then comes on saying how the firm's “valuation model” (which is driven by forward operating earnings and interest rates) implies that stocks are 20% undervalued.

Wall Street is presently managing trillions of dollars of other people's money on the basis of a single toy model, originally discovered in a packet at the bottom of a Cracker Jack box. Despite the superficial appearance of being some sort of discounting model (with the earnings yield in the numerator and the interest rate in the denominator), the Fed Model doesn't actually map into any reasonable model of discounted cash flow valuation without making odd and counter-factual assumptions about the relationship between growth, payouts, interest rates, and risk premiums.

The Fed Model asserts that earnings yields and Treasury yields have a 1-to-1 relationship, that stocks are undervalued anytime the earnings yield on the S&P 500 is higher than the 10-year Treasury yield, and that the gap between earnings yields and interest rates is the prime determinant of subsequent market returns.

It speaks volumes about the shallow analysis on Wall Street these days that all of these beliefs can be dispelled in a single chart.

There is, in fact, no stable relationship between earnings yields and interest rates. The relationship is actually negative in data since 1929, is marginally positive (but statistically insignificant) in data since 1950, and is only strongly positive in data from 1980 through 2000 as a statistical artifact of the disinflationary period from 1980 to 2000.....

It is that period since 1980 that is the entire basis for the Fed Model. In effect, the Fed Model looks at the decline in earnings yields since 1980, and loads the entire explanation on the decline in interest rates. What actually happened is that you had a second factor – the move from extreme undervaluation (abnormally high earnings yields) to extreme overvaluation (abnormally low earnings yields). The true “fair value” relationship between earnings yields and interest rates is nothing close to 1-for-1.

Statistically, the Fed Model simply doesn't work......

How much do interest rates affect the fair value of stocks?
In short, interest rates affect “justified” stock valuations when 1) the interest rate changes do not pass through to equal changes in earnings growth, and either; 2) the change in interest rates can be expected to be permanent, rather than damping out over time, or; 3) the change in interest rates is based on a security with the same effective duration as stocks. The historical data do not support the notion that fluctuations the 10-year Treasury yield should cause wide swings in “justified” stock valuations.

But that doesn't mean that interest rate fluctuations aren't important…

The importance of trends in interest rates
When we think about the effect of interest rates on the stock market, we have to make a major distinction between the level of interest rates, and the trend of interest rates.

What we've established so far is only that the level of interest rates (at least on the basis of short or intermediate term bonds) does not justify large changes in the “fair” multiple applied to stocks. Within a wide range of movement, changes in the level of interest rates normally warrant only one or two points of variation in “fair” P/E multiples. The remainder of the actual fluctuations in P/E multiples reflect changes in the long-term attractiveness of stocks.

Having addressed the question of "fair value," we can ask a different question – what happens when stocks become significantly overvalued or undervalued? Regardless of the level of interest rates, does the trend of interest rates affect how quickly valuations revert toward more normal levels? The answer here is a resounding “yes.”.....

.....In contrast, when valuations are high and risk premiums are already thin, rising interest rates contribute to upward pressure on risk premiums and downward pressure on stock prices (especially when interest rates are rising across a range of maturities, coupled with deteriorating breadth, overbought conditions, dull trading volume and other factors).

Consider a very basic cross-section of valuations and interest rate trends using data since 1950. Specifically, we'll place P/E ratios into 3 classes: below 12, 12-18, and above 18. We'll classify the 10-year Treasury yield as “falling” if it is below its level of 6 months earlier, and “rising” otherwise. Clearly, this is an extremely simplistic classification setup, but even here we can see the combined impact of valuations and interest rate trends. The following table provides the annualized total return and volatility for the S&P 500 based on each set of conditions.

Treasury yield falling

Treasury yield rising

Annualized return

Annualized volatility

Annualized return

Annualized Volatility

PE <>





PE 12-18





PE > 18





Notice that rising interest rate trends are invariably accompanied by weaker returns and greater volatility, regardless of the level of valuations.

So as noted at the outset, we often observe very good buying opportunities in stocks when valuations are cheap and interest rates suddenly decline. Conversely, we often see deep market declines when valuations are rich and interest rates suddenly advance. One need not use an inept tool such as the “Fed Model” to identify these instances.

Capitulating at the highs
.... At times like the present (as in 1999 and 2000) when the market advances despite conditions that have historically produced poor returns, it is easy to capitulate at the highs, and buy into a market that seems to be “running away.”..

For that reason, we can't have any assurance that the market will roll over into a bear market next week, next month, next quarter or even next year. But we can have reasonable confidence that markets will continue to cycle between great optimism and great despair. With stocks at over 18 times top-of-channel earnings on record profit margins, with the major indices at multi-year highs, with short-term trends easily through the upper Bollinger bands at the monthly, weekly and daily frequencies, with 54.3% of advisors bullish and only 19.6% bearish according to the latest Investors Intelligence figures, and with 10-year Treasury yields higher than they were 6 months ago, it should be reasonably easy to determine which extreme the market more closely resembles at present.

Overvalued, overbought, overbullish, yields rising. o-v-o-b-o-b-y. Hmm. That sounds familiar.

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