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Oft-Criticized Fed Model Says Stock Market Cheap; Investors Don’t Buy It

Stocks may offer upside vs bonds, but they’re still scary

Erin E. ArvedlundIn theory, U.S. equities offer more return than U.S. government bonds. But, wow, does it feel scary investing in the stock market these days.

The companies making up the Standard & Poor’s 500 index are throwing off an earnings yield that is quite high relative to the return on bonds; by this measure, stocks are inexpensive compared with fixed income.

Professional investors sometimes compare these two ratios — the earnings yield of the stock market and the yield on the 10-year Treasury bond — to determine which is undervalued or overvalued.

It’s called the Fed model, and I like this explanation from Investopedia:

Money managers compare the earnings yield of a broad market index such as the S&P 500 to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If higher, stocks may considered undervalued relative to bonds.

Right now, the Fed model says stocks are a bargain: Companies in the S&P 500 are collectively earning about 7 percent, an advantage over government bonds owing to the Federal Reserve’s policy of low interest rates. The 10-year U.S. Treasury is yielding a historically low 1.4 percent, and the Fed has promised to keep rates low (some say dangerously) until 2014.

But the volatility of the stock market is downright frightening, and the Fed is manipulating interest rates to make other assets more attractive.

So are stocks really cheaper, or does it just seem that way?

We checked in with a longtime pro, Ernest Cecilia, the new chief investment officer at Bryn Mawr Trust Co., who came over from recently purchased Davidson Trust, of Devon. He agreed that the stock market is cheap on this one basis, but added that he focuses on individual stocks instead.

The bank likes Unilever for client accounts. The giant household and consumer-products company generates half its business from emerging markets.

“There’s a stratification of income in the middle class going on in emerging markets. This is the kind of company that will grow there,” Cecilia said, and yields 4.1 percent in dividends and 7 percent earnings growth in the meantime.

Davidson Trust is Bryn Mawr Trust’s third recent acquisition in the trusts and money-management arena. In 2008, Bryn Mawr acquired Lau Associates, a financial-planning firm based in Wilmington, after buying the private-wealth-management group of Hershey Trust Co.

Bryn Mawr Trust, which now oversees $6 billion, is in the process of reviewing its investments, including mutual-fund families, he added. Among some Bryn Mawr Trust is jettisoning is Nuveen Tradewinds Emerging Markets Fund, which has had horrible returns. Bryn Mawr is adding some Lazard mutual funds.

In the U.S. government-bond market, Cecilia said, his company has been a seller of Treasuries since last summer. “We felt there wasn’t much value. We have been disinvesting, and moved that money into high-grade corporate bonds.”

That said, Bryn Mawr still holds some client account money in shorter-term Treasuries and Vanguard short- and intermediate-term corporate tax-exempt mutual funds.

But back to the ratio. Other investment pros, such as Barry Ritholtz, of Fusion IQ, have debunked the Fed model, arguing that the inputs into the two ratios are flawed. Analysts tend to overstate their earnings estimates for S&P 500 companies, and that skews the ratio.

“The Fed model assumes analysts’ consensus is accurate. That assumption has been the undoing of many an investor,” Ritholtz wrote in his blog, the Big Picture (www.ritholtz.com).

Anticipating the possibility of a recession, he has been adding Wal-Mart to his client accounts. Since it topped out in January 2000, Ritholtz wrote, “Wal-Mart’s stock has gone nowhere — until now. It has finally broken out to levels not seen in a decade.”


Read more columns at: http://www.philly.com/philly/business/personal_finance/20120612_Erin_Arvedlund__Stocks_are_offering_more__but_they_re_still_scary.html#ixzz1xaq0sP6N


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