Posted on: Monday, September 24, 2001
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A Flawed Model

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The cover story of the current Barron’s, “It’s Time To Buy Stocks”, claims that the market is now undervalued, based on a Greenspan Federal Reserve model popularized by Ed Yardeni of Deutsche Banc Alex Brown. As most of you know we have been saying for some time that the market is highly overvalued. (See, for instance, our comment of last Friday and our article entitled “Limbo, Limbo” as well as many other comments in our archives.) Since only one of us can be right, let’s examine the two sides of the issue. The Fed model used in the Barron’s article compares the interest rate on the 10-year Treasury Bond to the earnings yield of the stocks in the S&P 500. This earnings yield is the expected earnings of the S&P 500 divided by the current level of the index – in other words, the inverse of the forward price-to-earnings ratio. We believe that there are a number of serious flaws in this model, both on a theoretical and practical level. First, the index has worked fairly well only since 1980, and was not too useful prior to that time. In the decades prior to 1980 the market never sold at more than 22 times earnings despite the fact that there were numerous periods when interest rates were as low or lower than they are today. Second, following the lead of almost every strategist on Wall Street, the model uses operating earnings rather than reported earnings. The differences between the two are detailed in our daily comment of August 22nd. Briefly, reported earnings are net of almost all expenses while operating earnings add back all expenses designated as “special”. This gives management great latitude in excluding expense items that used to be considered routine business expenses, thereby inflating earnings. Prior to 15 years ago almost all earnings were “reported”. We use reported earnings in all of our calculations. Third, the article uses Yardeni’s 2002 operating earnings estimate of $55, which is a full 37.5% more than his estimate for 2001. This is virtually the same number the consensus was using before the terrorist attack, and the estimates were coming down rapidly even then. None of the market pundits had any idea what earnings would be in 2001, yet they consistently come forth with outlandish guesses for next year. With layoff announcements accelerating, we believe that strategists will continue to revise their forecasts downward for both this year and next. We continue to believe that price-earnings ratios are the only measurement of stock market values that have withstood the tests of time through all kinds of conditions (high inflation, low inflation, high interest rates, low interest rates, war and peace). We show (with the help of charts from Ned Davis Research) the P/E today relative to every peak and trough over the past 75 years. The current P/E is higher than at any previous bull market top, let alone bear market bottom. The market is highly overvalued no matter what the Fed model says. Let the Fed do their job, and we’ll do ours.
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