Asset management
What make the stock market tick?
Many efforts have been made over the years to develop ways to determine whether the stock market as a whole is underpriced or overpriced. Benjamin Graham suggests that what we are looking for is to decide whether stock prices are “less or more attractive by value standards”. This is a different exercise that trying to value a single business to see whether its stock price is very attractive by value standards.
From the perspective of about 1990, traditionally, investors had tended to answer the question of whether the stock market was over or underpriced by looking at the general level of Price/Earnings ratios without factoring in the level of interest rates. This called for the use of the past year’s earnings, the trailing twelve-month earnings or the year to come estimated earnings, in considering the Price/Earnings ratio of the stock market as a whole.
Even at the present time, much the same approach is taken. Occasionally today mention is made of the fact that bonds and stocks compete for investors’ dollars and, if at some point interest rates go down, this would favor stocks over bonds and vice versa. However, more is made of a comparison between the Price/Earnings ratio of the S&P 500 taken in aggregate to its historic levels. For example, at the date of this writing, many commentators are offering suggestions to investors on the basis that historically the S&P 500 has traded at a multiple of price to earnings of about 18 times. Thus, commentators conclude that if the S&P 500 trades at a Price/Earnings ratio over 18 times last year’s earnings it is ‘less attractive by value standards’. Does this make sense?
Advent of the Fed Model
In 1997, an approach to valuing the stock market as a whole received a name. It was called the ‘Fed Model’, although it was never formally adopted or used by the Federal Reserve. It compared the earnings yield on the stock market as a whole with the yield on ten-year government bonds. The S&P 500’s earnings yield is simply the inverse of its Price/Earnings ratio.
According to the Economist Magazine of August 3, 2013 in a Buttonwood article, the Fed Model “was based on a reference in Alan Greenspan’s 1997 congressional testimony to the close relationship between the ten-year bond yield and the earnings yield (the inverse of the price-earnings ratio) on the S&P 500 index. If the earnings yield was higher than the bond yield, then equities were cheap. Bond yields and earnings yields did indeed seem to move in tandem for about 15 years, and then the relationship broke down completely at around the turn of the century.” (Emphasis Added)
That is, during the period from 1980 to 1997 there was an apparent connection between the S&P 500 prices and the value of the stock market derived from the Fed Model. And then, after about 2000, bond yields and earnings yields seem to lose their relationship.
A chart depicting this was included in the article. The Economist article added: “But should it work in theory? The common rationale for the Fed model relates to the ‘discounted cash flow’ approach to valuing equities. Lowering the discount rate you apply to future cash flows increases present value (the share price), other things being equal. The trouble is, other things aren’t equal.” The article then goes on to point out that bond yields can fall because of falling inflation expectations, or because of fears about economic growth or because yields are manipulated by the Federal Reserve through quantitative easing and twist programs.
The Fed Model is in many ways consistent with the accepted method of valuing both stocks and bonds. For example, Warren Buffett is quoted by Lawrence Cunningham as follows:
“In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same of stock as for bonds.” (Buffett W. E. The Essays of Warren Buffett: Lessons for Corporate America. 1998) p 86
Thus, value is estimated from future cash flows and a discount rate. Note, there is a difference between earnings and cash flow.
Flawed in the way it deals with inflation
In 2002 an often-cited paper was published written by Clifford S. Asness of AQR Capital Management, LLC. titled: “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns”.
The paper looked at the theoretical underpinnings of the Fed Model and concluded the model was flawed in the way it deals with inflation. The model is said to confound nominal corporate earnings and inflation adjusted corporate earnings. As noted, the correlation between the Fed Model and the S&P 500 broke down following 1997. The model seemed not to work anymore.
According to Asness, the traditional approach of comparing the Price/Earnings ratio of the stock market as a whole to historic Price/Earnings levels seemed to provide “strong forecasting power”, that is, it was a better yardstick as to whether the stock market as a whole was fairly valued.
Asness accepted that the overall Price/Earnings ratio of the stock market was indeed higher in low interest rate environments and lower with high interest rates. What he found was that “this relationship is somewhat more complicated than described by the simple Fed Model, varying systematically with perceptions of long-term stock and bond market risk.” (Emphasis Added)
That is, the level of interest rates counts. It’s just that there are other factors at play.
With this in mind, it would seem better to treat long term bond yields as simply one consideration when trying to determine if the stock market is overpriced. In the Motherlode section titled The Stock Market and the Economy, I looked at what Warren Buffett describes as the factors that make the stock market tick. They were interest rates, investor expectations for profits and investor confidence. The Fed Model was too simple but it was not in error in taking interest rates into account.
Based on what I write below we should change ‘investor expectations for profits’ to ‘investor expectations for cash flows’.
Fed Model today
Here’s a recent comment by a well-known money manager David M. Einhorn. I imaging it reflects what a lot of investors think.
“The market is about the most expensive that it’s ever been in the history of the time that I have been managing the fund,” Einhorn warns. With risk premiums at “roughly zero versus government bonds, equity investors are not being compensated for their exposure.” (Emphasis Added)
He continued: “As of 12/31/2024, their collective forward earnings yield is under 3%, a significant discount to the 4.68% 10-year yield. Mr. Market appears to be discounting significant long-term benefits of AI and the continuation of double-digit earnings growth well into the future. With valuation multiples and profit margins at the higher end of their historical range, there is a growing risk of another valuation contraction cycle, potentially triggered by any unforeseen disappointment on future earnings or weaker-than-expected free cash flow due to escalating capital expenditures.”
David M. Einhorn is an American investor, hedge fund manager, and amateur poker player. He is the founder and president of Greenlight Capital, a “long-short value-oriented hedge fund”. Born in New Jersey, Einhorn graduated from Cornell University, before starting Greenlight Capital in 1996. Wikipedia
He comments frequently on the stock market. See here and here for example.
Risk premiums
A word about risk premiums. Einhorn says above: “With risk premiums at “roughly zero versus government bonds,” etc.
This is one way to calculate risk premiums. It may not be the best way.
One of the worlds leading experts on the equity risk premium is Aswath Damodaran. He is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation. He regularly publishes an updated paper on the equity risk premium. Damodaran has calculated that in January 2025 the Equity Risk Premium stood at 4.33%. That is, equity investors (S&P 500) could expect a return of 4.33% over so called ‘risk free’ ten-year treasury bonds. See my post The price of risk in equity markets
The forward earnings yield for the market as a whole, as used by Einhorn, gives you a completely different take on risk premiums.
Forward earnings
Einhorn is putting a lot of weight on the overall market’s forward earnings yield compared to the ten-year government bond yield. He says the “collective forward earnings yield is under 3%”.
The forward earnings yield is calculated using estimates of earnings. The problem is that reported earnings don’t capture the economic performance of companies the way earnings used to do forty or fifty years ago. This is because of the dramatic increase in company investment in intangibles of lasting value that are expensed against earnings. If your input is unreliable, your conclusion will be also. No need to repeat what I have written before. See my posts:
Investment in intangibles has wreaked havoc on the meaning of multiples
Value investing in the age of the Magnificent Seven, networks, intangibles, AI and all that
Conclusion
There are three problems with the use of forward earnings yield vs the ten-year government bond yield as an indicator of whether the stock market is overpriced: First, there are other factors at play other than expected earnings and interest rates; Second, the difference between the forward earnings yield and ten-year government bonds will not give you a proper Equity Risk Premium; And third, earnings and book value have become substantially obsolete and misleading as inputs in various multiples.
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