David Tepper was on CNBC this morning arguing that stocks are historically cheap:
[Tepper] said the post showed “when the equity risk premium is high historically, you get better returns after that.” He continued, “So we’re at one of the highest all-time risk premiums in history.”
In making his argument Tepper referred to this article, Are Stocks Cheap? A Review of the Evidence, in which Fernando Duarte and Carlo Rosa argue that stocks are cheap because the “Fed model”—the equity risk premium measured as the difference between the forward operating earnings yield on the S&P500 and the 10-year Treasury bond yield—is at a historic high. Here’s the chart:
Here’s Duarte and Rosa in the article:
Let’s now take a look at the facts. The chart [above] shows the weighted average of the twenty-nine models for the one-month-ahead equity risk premium, with the weights selected so that this single measure explains as much of the variability across models as possible (for the geeks: it is the first principal component). The value of 5.4 percent for December 2012 is about as high as it’s ever been.The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then.
The Fed model seems like an intuitive measure of market valuation, but how predictive has it been historically? John Hussman examined it in his August 20, 2007 piece Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios. Hussman writes:
The assumed one-to-one correspondence between forward earnings yields and 10-year Treasury yields is a statistical artifact of the period from 1982 to the late 1990’s, during which U.S. stocks moved from profound undervaluation (high earnings yields) to extreme overvaluation (depressed earnings yields). The Fed Model implicitly assumes that stocks experienced only a small change in “fair valuation” during this period (despite the fact that stocks achieved average annual returns of nearly 20% for 18 years), and attributes the change in earnings yields to a similar decline in 10-year Treasury yields over this period.
Unfortunately, there is nothing even close to a one-to-one relationship between earnings yields and interest rates in long-term historical data. Why doesn’t Wall Street know this? Because data on forward operating earnings estimates has only been compiled since the early 1980’s. There is no long-term historical data, and for this reason, the “normal” level of forward operating P/E ratios, as well as the long-term validity of the Fed Model, has remained untested.
Ruh roh. The Fed model is not predictive? What is? Hussman continues:
… [T]he profile of actual market returns – especially over 7-10 year horizons – looks much like the simple, humble, raw earnings yield, unadjusted for 10-year Treasury yields (which are too short in duration and in persistence to drive the valuation of stocks having far longer “durations”).
On close inspection, the Fed Model has nearly insane implications. For example, the model implies that stocks were not even 20% undervalued at the generational 1982 lows, when the P/E on the S&P 500 was less than 7. Stocks followed with 20% annual returns, not just for one year, not just for 10 years, but for 18 years. Interestingly, the Fed Model also identifies the market as about 20% undervalued in 1972, just before the S&P 500 fellby half. And though it’s not depicted in the above chart, if you go back even further in history, you’ll find that the Fed Model implies that stocks were about as “undervalued” as it says stocks are today – right before the 1929 crash.
Yes, the low stock yields in 1987 and 2000 were unfavorable, but they were unfavorable without the misguided one-for-one “correction” for 10-year Treasury yields that is inherent in the Fed Model. It cannot be stressed enough that the Fed Model destroys the information that earnings yields provide about subsequent market returns.
The chart below presents the two versions of Hussman’s calculation of the equity risk premium along with the annual total return of the S&P 500 over the following decade.
Source: Hussman, Investment, Speculation, Valuation, and Tinker Bell (March 2013)
That’s not a great fit. The relationship is much less predictive than the other models I’ve considered on Greenbackd over the last month or so (see, for example, the Shiller PE, Buffett’s total market capitalization-to-gross national product, and the equity q ratio, all three examined together in The Physics Of Investing In Expensive Markets: How to Apply Simple Statistical Models). Hussman says in relation to the chart above:
… [T]he correlation of “Fed Model” valuations with actual subsequent 10-year S&P 500 total returns is only 47% in the post-war period, compared with 84% for the other models presented above [Shiller PE with mean reversion, dividend model with mean reversion, market capitalization-to-GDP]. In case one wishes to discard the record before 1980 from the analysis, it’s worth noting that since 1980, the correlation of the FedModel with subsequent S&P 500 total returns has been just 27%, compared with an average correlation of 90% for the other models since 1980. Ditto, by the way for the relationship of these models with the difference between realized S&P 500 total returns and realized 10-year Treasury returns.
Still, maybe the Fed Model is better at explaining shorter-term market returns. Maybe, but no. It turns out that the correlation of the Fed Model with subsequent one-year S&P 500 total returns is only 23% – regardless of whether one looks at the period since 1948 (which requires imputed forward earnings since 1980), or the period since 1980 itself. All of the other models have better records. Two-year returns? Nope. 20% correlation for the Fed Model, versus an average correlation of 50% for the others.
Are stocks cheap on the basis of the Fed model? It seems so. Should we care? No. I’ll leave the final word to Hussman:
Over time, Fed Model adherents are likely to observe behavior in this indicator that is much more like its behavior prior to the 1980’s. Specifically, the Fed model will most probably creep to higher and higher levels of putative “undervaluation,” which will be completely uninformative and uncorrelated with actual subsequent returns.
…
The popularity of the Fed Model will end in tears. The Fed Model destroys useful information. It is a statistical artifact. It is bait for investors ignorant of history. It is a hook; a trap.
Hussman wrote that in August 2007 and he was dead right. He still is.
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[…] See my earlier post on the Fed model “How predictive is the Fed model?“ […]
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I don’t understand your focus on Fed model.
Tepper said stocks are cheap in reference to the recently published Fed paper.
The paper averaged 29 different models, not just “Fed model”.
Quote:
“The equity risk premium is the expected future return of stocks minus the risk-free rate over some investment horizon. Because we don’t directly observe market expectations of future returns, we need a way to figure them out indirectly. That’s where the models come in. In this post, we analyze twenty-nine of the most popular and widely used models to compute the equity risk premium over the last fifty years. They include surveys, dividend-discount models, cross-sectional regressions, and time-series regressions, which together use more than thirty different variables as predictors, ranging from price-dividend ratios to inflation.”
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I might be wrong, but as far as I am aware, there’s no consensus on the Fed’s model used to calculate the “expected future return of stocks,” which is why Hussman calculates it twice using two different metrics, and Duarte and Rosa use the average of 29. Either way, they’re still using a composite / average of those models to calculate the equity risk premium, which is the Fed model (the expected future return of stocks minus the risk-free rate over some investment horizon). Hussman’s point is that the Fed model doesn’t work because netting out the risk-free rate destroys the information in the other portion of the model e.g. the raw earnings yield, unadjusted for 10-year Treasury yields, more closely predicts the actual returns of the market.
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From an overall portfolio/diversification standpoint, we find that the “fed model” concept is more powerful than looking at absolute price ratios: http://empiritrage.com/2013/05/03/tactical-asset-allocation-during-cheap-markets-may-2013/.
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Equities outperform bonds at extreme real yields? Is it fair to say that, given the current extreme real yield, you expect equities to outperform bonds here, but you anticipate attenuated returns for both equities and bonds?
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Here’s a paper from 2002 with similar findings.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480
A couple of choice quotes:
“One does not have to turn on CNBC or the like for more than about 15 minutes to hear a strategist. portfolio manager. or market pundit of some stripe explaining that the high market multiples of recent times are justified by low interest rates and or inflation. “Well Maria, you have to understand, stocks might look expensive, but it is O.K. as interest rates and inflation are low.” Or, so the refrain goes.”
“Of course, now is the time for the rub. While there are no bright line answers to a question with many dimensions, for most intents and purposes the above “common sense” arguments are wrong, and the Fed Model is fallacious as a tool for long-term investors.”
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How is Hussman wrong on this? Never mind his record – although that has been miserable over the last few years.That does not invalidate his thoughts on the Fed model.
Personally I think JH is an intellectual capacity in an industry full of quacks who often refer to models that don’t work instead of historical data. I would like to hear what is wrong with his evidence in this regard.
David Tepper is a brilliant investor, (not a quack) but note that he did not say that stocks are a great value over the next ten years for example. Just that they will go up for a while. Which they may very well do. But not because they’re a good value.
http://www.klarmanite.com/blog
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David Tepper is a model human being whose example should be followed, blindly, by all others because his great financial success proves it “works.” For example, Tepper recommends front-running the Fed and essentially bases his current strategy around arbitraging uneconomic behavior caused by violent interventions in the financial marketplace. There are no risks to this strategy and he can’t possibly be wrong for suggesting it because he hasn’t been wrong so far. We all should be so wise as to think, speak and act more like David Tepper.
Hussman is a fund manager. A fund manager wins by accumulating AUM and charging fees on it, not by getting great returns for their investors. By this account, I think Hussman has done quite well for himself. Maybe we should consider what he has to say, now?
Or else we could consider all the fund managers who have losing track records who advocate the Fed model? And then reject the Fed model by looking at their performance?
Bubble times produce clownish thinking because it’s easy to become detached from reality, the authorities doing everything they can to ruin such common, tangible reference points with their policy. The two boneheads who have stopped by here today are cases in point.
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Hussman may be misguided in how he uses his models for investment purposes, but this doesn’t invalidate the models’ conclusions. It is near impossible for an investment manager to use long-term valuation models for day-to-day investment decisions because he would spend a very large portion of time out of the market (see here for an example: http://gestaltu.blogspot.ca/2013/01/the-full-montier-absolute-vs-relative.html). Thus Hussman is forced to use other short-term tools to dance while the music is playing. Clearly his short-term tools haven’t worked so well.
Hussman’s models have worked brilliantly to forecast actual market real returns over ten year horizons since he first published his model forecasts over 10 years ago. It’s foolish to ring the death knell on long-term models near a market peak half way through a cycle. Let’s see how the model bears out at the bottom of the next bear – unless the Fed has rendered bears extinct.
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“The popularity of the Fed Model will end in tears. The Fed Model destroys useful information. It is a statistical artifact. It is bait for investors ignorant of history. It is a hook; a trap.
Hussman wrote that in August 2007 and he was dead right. He still is.”
> Better to say investing with Hussman will end in tears. Over the last 10 years, Hussman is down over 20% while the market is up over 70%.
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Fair enough, but I think his examination of the Fed model is correct.
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Why do you keep referring to Hussman. This guy runs an actual fund. It has done terribly. His big product, Strategic Growth, got killed in 08, and has continued to fall since. His other big fund, Total Return, has also underperformed. I’m not talking about the last few months, but long term. I suppose he could be right intellectually, but execute wrong. I doubt it.
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I like his examination of the Fed model here.
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