Let’s put aside the question of whether the Fed Model is theoretically or empirically valid. The Fed Model certainly has some high intellectual horsepower critics in guys like Hussman and Asness. The more important issue might be how many in the investment world believe it is valid (and the AUM they control and buy/sell decisions they make) rather then whether it is actually a valid method for valuation of the broad stock market.

At the end of the day, the stock market is an auction market and as much as “valuation” might matter, especially in the long-term, it is ultimately supply and demand that determines the prices of securities. Ultimately, if the demand for stocks at current valuations is stronger then supply because the overwhelming majority of market participants believe in and are acting on the Fed Model, that may be the most important thing to realize about where stock prices are headed at least in the short-term. Stocks are worth whatever somebody else is willing to pay for them, and those people who believe in and act on the Fed Model are willing to pay current prices.

Based on what I read in the press, the blogs, and see on CNBC, it sure seems to me that the overwhelming majority of institutional money believes in using the Fed Model as a valuation tool (and I assume are actually acting on it), and presumably we are talking about hundreds of billions, if not over a trillion dollars of money under control.

Here is just a recent sampling of seeking alpha articles to support the idea that most are in fact using the Fed Model to make their decision to buy stocks:

http://usmarket.seekingalpha.com/article/41008
http://usmarket.seekingalpha.com/article/40945
http://usmarket.seekingalpha.com/article/31452

This is more then just an academic question to me. I currently have a roughly 30% cash allocation (after recently selling most of my REIT allocation), and a fairly high allocation to a defensive mutual fund (probably not hard to guess what it is). I’d be lying if I didn’t say I am concerned about potential underperformance if this market continues rising over the next 1-2 years, and I think it is a reasonable possibility we are entering a final blow-off parabolic stage to this bull market similar to 1998-early 2000. Ultimately, I think it will end very badly but in the meantime those cautious/bearish on the market may continue to look “stupid”.

I would like to send you an email if you are ok with it – I can be contacted at james@teamfinancial.net

I too have a large investment in Hussman and I have some input for you on the commodities question.

AA,

I’m not David, but I’ll take a stab at this. My definition of “absolute cheapness” is a valuation level that is likely to deliver above-average long-term returns where long-term returns is at least 5 years and preferably 10 years, and above-average means at least greater than 10-11% which is the VERY long-term average for stocks. It seems almost obvious to me by definition that stocks were cheap in the past when they ended up delivering above-average long-term returns, and were expensive in the past when they ended up delivering below-average long-term returns. I’m not sure what other definition could make sense.

Based on the research I’ve read and studied from what I consider the sources who have done the best quantitative analysis on this subject (Hussman, Crestmont Research, James Montier) the single best indicator of the absolute cheapness of stocks is the P/E ratio or earnings yield IRRESPECTIVE of what interest rates happen to be. Low starting P/E ratios have been followed by high stock returns, and high starting P/E ratios have been followed by low stock returns. The following graph from Crestmont is instructive:

http://www.crestmontresearch.com/pdfs/Stock%2020%20Yr%20Returns.pdf

Now there are those who argue that essentially all data and historical experience prior to 1980 is irrelevant. I’m not sure how you can prove that point one way or the other, except that my opinion would be the more data the better.

Geoff Gannon has posted a great series of articles on valuation on seekingalpha (I think he has a blog as well). Bottom line, we have basically been in uncharted territory since 1996 and on. I see 2 outcomes:

1. We are in a new era of permanently higher valuations that will be maintained indefinitely and long-term returns from stocks will be below their long-term 10-11% average, or

2. At some point we will revert to more normal historical valuation levels. This will result in a substantial decline in stocks, but provide the starting point for higher returns going forward from that point on.

My focus at this point is trying to strike a balance between those 2. I think a middle ground of being cautiously bullish and focusing on stocks with attractive relative valuations makes sense. My sense is individuals like Hussman and Grantham are probably correct in their valuation concerns, but that this present market still has to go through the final parabolic blow-off stage.

Finally, go to pimco.com, and check out Markowitz’s critique of CAPM. You’ll enjoy it, I think!

You and one of the commenters mention John Hussman. As I’m sure you are aware, he has written several pieces in recent weeks critical of the Fed Model and pointing out that the role of interest rates in setting fair value for stocks is overstated. FWIW, I’m a regular reader of his weekly commentaries and have a large stake in the Hussman Strategic Growth fund for myself and client portfolios. I hope you don’t mind but I took the liberty of e-mailing him a link to this note. It’ll be interesting to see if he addresses your argument in a future weekly note.

As far as I can determine, your arguments in this note are completely rational and logical, and well supported by a lengthy historical quantitative analysis. This is the complete opposite of most of what I’ve read on the Fed Model advocate side. Most of what I’ve encountered basically amounts to hand-waving with no data support or extremely short time frames.

In any case, I am trying hard to reconcile your piece with Hussman’s recent notes. I am thinking that perhaps there is no contradiction. The focus of Hussman’s notes have been the absolute valuation on stocks and likely long-term (5-10 year) returns while you do point out the Fed Model is more about the relative valuation between stocks and bonds. In that sense, it seems like 95%+ of investment strategists are misusing and misapplying the Fed Model. They are using it to proclaim that stocks are screaming bargains while if you look at a metric like P/E and use 10-year average earnings stock valuations are about as high as they have ever been.

I guess the conclusion is to definitely avoid LT bonds, and keep any fixed income very short duration.

A bit off the subject, you mention other asset classes. I have a pretty hefty allocation to commodities, and I’m definitely in the commodity supercycle camp (Jim Rogers) and think there is alot of upside still there over the next 5-10 years. However, I am reevaluating my exposure because I am using a mutual fund that basically copies a passive index and uses the rolling futures strategy. Others and yourself have pointed out the distorted futures curve causing persistent losses on the roll. Do you have any solutions/ideas here?

I think the historical back testing raises a few issues. The 54 year period includes two secular bull markets and only one secular bear and the current end point is near all time highs. Using normalized profit margins, the average stock is at the very high end of the top historical decile for valuation. It also includes a 25 year period where the financial profits have grown to close to 50% of earnings and debt as a percentage of GDP has grown to 350% from around 100%. This explosion in financial profit growth due to leverage is very hard to replicate. This has largely been possible due to the dollars reserve currency status, but what are the chances that the dollar retains the same level of stature and debt to GDP goes to 600% over the next 25 years? Anything is possible but I find that outcome highly unlikely.

A truly global examination of history indicates that the US’s 20th century emergence and run as the largest global economic and political power is unlikely to continue. Many of the imbalances often sited are typical late-dynasty indicators. Whether it were the Spanish of the 17th century, the Danes of the 18th century or the British of the 19th century, all started their demise as we have – inflating currency with massive debt growth combined with imperial war.

Therefore, I would argue that the general underlying assumption that capitalist economies will grow at a 6-7% rate is faulty. This has likely been true historically during their maturity phase, but not in their decline. Growth rates have been much faster in their emerging phase – like the US in the late 1800′s, the Japanese in the 1960′s-1970′s and China today.

Of course, these are largely qualitative factors/risks, but then that is why value investing involves a margin of error. I doubt that Ben Graham would look at the average stock today as anything other than grossly overvalued.

You mentioned, “One day I will write an article to explain my cost of equity capital methods in more depth.” I look forward to that. I was curious what you thought of Bloomberg’s WACC function.

After reading your link critiquing Bloomberg’s DDM, I would be curious to read you take on WACC and the EVA spread (economic value added, of course).

As always, thanks for the years of sharing your thoughts.

The asset class that many individual investors have opted for is real estate.

You are quite correct in portraying the Fed model as a stocks versus bonds choice (with cash being a close equivalent these days). The gap reflects the widespread skepticism about future earnings, despite the multi-year pattern of companies beating expectations.

I’ll try to write something more careful and link to you, but meanwhile, any thoughtful investor should appreciate your careful analysis.

Jeff