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Fed Model's Dog Don't Hunt


Greatest credit unwind of all time requires higher risk premium.


"Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception."
-George Soros

Most days when I'm getting ready to head into the office, I try to get a pulse of what others think about the markets. After all, we must study the behavior of others to get a sense of how to be properly positioned as the crowd is usually wrong, particularly at extremes.

What strikes me now is that the majority of professional investors I listen to are uniformly bullish and that stocks are cheap, particularly when compared to Treasury notes. I suppose, that in a vacuum, and only using the "Federal Reserve Model" as your guide, stocks are indeed cheap, just like they have been cheap for the past eight years. However, take a wild guess at what the total return has been for the past eight years for the S&P 500, including dividends: +0.8% per year, hardly inspiring.

S&P 500 Total Return Since March 2000

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The "Fed Model" is a very simplistic view of how stocks and bonds should be valued in relation to each other. Specifically, it states that the real yield of U.S. Treasury Bonds should be similar to the S&P 500 earnings yield (the forward earnings divided by the current index level).

If you believe the IBES2 number of $93 or so in S&P 500 earnings for 2008 (I clearly do not), it computes to a yield of 6.83% ($93 earnings/1360 index level) or a multiple of 14.6 times earnings (1360 index level/$93 earnings). This makes stocks look cheap against a 10 year U.S. Treasury yield of just 3.91%, which is a multiple of 25.5 times earnings (1/3.91% yield).

Issue #1: The big problem that I have with this stock market earnings estimate is that it excludes those pesky write-downs, like the $200 billion or so that have been taken in the past year by financial institutions (a number that in my opinion, could swell to over $1 trillion in the coming year or two).

Issue #2: Allow me to say this in the nicest way possible. If the only two instruments that you are using as a professional money manager are the 10 year Treasury note and the S&P 500 Index, I would suggest that you'd better look for another job, because as they say down here in the South, "That dog doesn't hunt."

The Fed Model Chart

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A Different Benchmark

I spent the first 15 years or so in the securities industry as a sell-side institutional salesperson/trader. The main focus from 1987 to 1997 was high grade Mortgage Backed Securities (MBS). A couple of features that attracted me to MBS (particularly high coupon MBS explicitly backed by Uncle Sam - like GNMAs) were that they were safe and provided me with tons of income and no credit risk. As an absolute return investor, having a dependable stream of income and no credit risk is very important in determining how much money we can spend on risk. The more dependable and the higher the return the better.

So now, rather than blindly using 10 year Treasuries as my "risk-less benchmark," I use the Ginnie Mae (GNMA) pools with the best overall risk profile as my "risk-less benchmark" to see if stocks are cheap or not. I've been purchasing GNMA 6% pools aggressively in recent days at yields in excess of 5.65%, assuming a Constant Prepayment Rate (CPR)3 of 15%. The duration of this security is only 4.15 years, which is much less than the current 8.31 year duration of the 10 year note. In other words, I'm able to earn 1.72% more per year with half of the volatility and still maintain a no credit risk profile (an earnings ratio of 1/5.65% or 17.7).

So when you use GNMAs as a proxy for the risk-free benchmark instead of 10-year U.S. Treasuries, we have stocks at 14.6x earnings, with GNMAs at 17.7x earnings. See the GNMA 6% Pool Screen-Shot here.

To determine what price to pay for stocks, we must add a "risk premium" for taking on the risk of owning stocks in the first place (forgetting for a moment that we're in a secular bear market which makes the risk of ownership even higher). Risk premium is defined as "the amount above the risk-free rate that investors seek before they will put money into a risky asset." Most academics use 2.5% as their risk premium input, which suggests that I would need to earn 5.65% (GNMA yield) plus 2.5%, or 8.15% per year in order to own the S & P 500 on a risk adjusted and earnings equivalent basis.

But this is where my methodology differs from many others and is directly tied to my view on the macro-economic picture, and more specifically, the credit crisis that I believe is now in unwind mode (recall my piece from last week). If we're currently in the midst of the greatest credit unwind of all time and the macro-economic picture has not been this bleak since the 1930's, we must layer another risk premium in, which for me is another 5%. This now takes a return of 8.15% plus 5%, or 13.15% per annum over the next 5 to 10 years to entice me out of my GNMA 6% pools into the S&P 500.

But this is where it gets dicey as we must determine what the actual GAAP earnings number is for the S&P, and the current GAAP earnings number for the S&P 500 is currently $59.83, according to Bloomberg, resulting in a price/earnings ratio of 25.5 and a dividend yield of 2.24%. See a Bloomberg Screen Shot of Actual versus Estimated Earnings for S & P 500 here.

Now that we have the inputs necessary to calculate what price to pay for stocks in order to be compensated for owning them in the first place, let's take a look if stocks are cheap as many pundits tell us on daily basis. The assumptions I will use in the table below assume the 10 year Treasury note yield, the GNMA 6% yield, The GNMA plus 2.5% risk premium yield, and the additional risk premium allowed for the macro-economic mess we find ourselves in. The results, to say the least, are sobering and is what keeps me so cautious towards credit risk and equities.

Potential Price Targets for S & P 500 Index

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The takeaway from this chart is rather simple. The most optimistic viewpoint is from the Fed Model, which assumes that if you believe that stocks should trade at the inverse of the 10 year Treasury yield and you believe the $91.95 number, then stocks should trade at 2068, or 52% above Friday's close.

Taking the most draconian viewpoint yields a much more pessimistic target of 456, which is a 67% drop even after this past Friday's move down. This negative output assumes we would want to earn 13.15% yield in stocks after adjusting for our risk premium (stock market + macro view), and adjusting down the actual S&P 500 earnings expectations from $93 per share to the actual $60 GAAP earnings currently. Interestingly, $60 earnings on an index of 456 is a multiple of 7.6x, a level that is not abnormal for secular bear market lows.

Personally, I think the $60 number is the one to use as it is the factual assessment of how much money has been made over the past 12 months. My reasoning is rather simple-the companies that are writing the assets down (note "write-down," not "write-off"), are hopeful that they will be able to write them back up at some point in the future. If this is indeed the case, investors would use that number to increase their price target for the S&P, the write-downs must be included.

I suppose that I find myself in the 735 camp, or a stunning 46% drop from here. It should be noted that the S&P bottomed at 765 in 2002, when the economy was on much more solid footing before all of the financial alchemy started and before money growth exploded. So if you believe that 735 is a draconian view, I actually find it to be my most optimistic target for the S&P 500 in the coming two years as I feel that the $60 earnings per share number will actually prove to be too high.

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The credit crisis reminds me of a black hole, where one by one, industries are being sucked into the abyss. This is without the energy and food crisis, which only exacerbates matters. The crisis has spread from mortgage brokers to investment banks to commercial banks to retail and so on. The credit crisis is sucking in everything in its path, and is otherwise known as contagion.

The credit crisis is anything from contained, as many perma-bulls would like us to believe.

If a move to 735 were to occur over the next couple of years, we would consider that to be an opportunity within the context of an ongoing secular bear market in equities that began in either April 1998 (the NYSE Advance/Decline Line peaked then) or in March 2000. Markets are like the people that control them-emotional. And the emotional roller coaster called the stock market tops out in times of greed and bottoms out in times of despondency.

I can say that as someone that began as a retail stock broker in 1981, it was no fun 'cold-calling' potential investors when they had just been through a 15 year bear market. Interestingly, take a wild guess what the P/E ratio of the S & P was back then-7.5. Granted, inflation was high and interest rates were high, but the balance sheet of America was much better then, leverage was low and net cash levels were very high. Back then, I couldn't give stocks away. At any rate, stocks tend to bottom after 16 year annualized trailing returns bottom in the -4% to 0% range. Think about it, who would want to buy something that had returned nothing but grief for the last 16 years, but this is, of course, the time to be a buyer.

Investor Sentiment Chart

I guess you could say that March 2000 marked the 'Euphoria' part of the sentiment cycle and that 'Anxiety' began 2007 when the credit crisis reared its ugly head and I continue to believe that most are in 'Denial' about the current state of affairs, which seem to worsen by the day.

Believe it or not, as cautious I have been over the past 10 years, I am now the most cautious of my entire career. The Perfect Storm has indeed formed, but if I am wrong about all of this , and magically the market and economy and credit woes magically heal themselves, I will have lost opportunity, but not capital.

I think the 'Fear' stage will show itself in the next 2 years and that will mark an interim bottom, followed by a nice bounce, and then one last move that takes us to 'Despondency'. If I am correct, I will then have lived through a secular bull and a secular bear just in time to hand over the controls to the younger and very gifted portfolio managers in our organization at which point I can begin writing about the new secular bull market!

Annualized 16-Year Returns for DJIA

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Whenever I find myself feeling very optimistic (yes that can happen) or rather pessimistic, as I find myself at present, I like to double and triple check my data points. While I am proud to have gotten the credit market call correct for the past few years, I am deeply troubled by what I sense lies ahead for us as a country and as investors. Below I will provide some data, courtesy of Ned Davis Research, that confirms that indeed, equities are over-valued from a long-term perspective. I do understand the argument that tax treatment is different now for corporations than in prior cycles and that we are no longer a society that makes things and that we are service-based economy.

Many believe that we should conclude that this makes it "different this time." I couldn't disagree more vehemently. I feel the only way it is different this time is in a negative way-That is, that the unparalleled build-up of debt and credit will lead to an unprecedented bloodbath in the future.

S&P 500 P/E Chart using GAAP Earnings

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S&P 500 Dividend Yield Chart

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DJIA Price to Book Chart

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Perhaps the biggest problem coming is profit margins. As a business owner, I'm keenly aware of the inputs that influence profit margins. We all have fixed costs such as rent, payrolls, etc. I sense a lethal combination (a perfect storm for profit margins?) coming together as it relates to profit margins. These inputs include higher unemployment, higher commodity prices, and increasing credit costs, all amid a shrinking economy. If the economy slows, margins shrink and the credit crisis intensifies, it makes one wonder if the possibility for much lower equity prices doesn't indeed lie ahead, regardless of valuation models.

S&P Industrial Average Profit Margin

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In summation, I want to, in the worst way, to be optimistic when I sit at our trading desk each day. I am not, in the least, a pessimist at heart. However, I have learned (the hard way, by making mistakes) that the key to winning is first to not lose.

An analogy for fellow golfers is to think about when it makes sense to chip out and when to "go for it." We all make mistakes, we all hit it in the woods sometimes, but we need to keep mistakes small and not try for the miracle shot. This is one of those times. As the quotation at the outset of this piece suggests, bubbles start in a somewhat innocuous way, but they tend to end in a rather insidious way. I see no reason to believe that "this time is different."

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