Wednesday, May 2, 2012

The Maestro Returns

Former Fed Chairman Alan Greenspan, who was dubbed "The Maestro" at the peak of his influence before the housing bust and financial crisis ruined his reputation, opined on the stock market the other day.

He said stocks are "very cheap" and likely to rise.  However, he cited his widely used--but completely refuted by market history--"Fed Model."  The so-called Fed Model, which he invoked in the late 1990's, compares the "earnings yield" of stocks to the yield on U.S. Treasury Notes so as to assess the relative attractiveness of the two asset classes.  The earnings yield is the inverse of the p/e ratio.  So, with the S & P 500 now selling at about 13 times forecast operating earnings, 1/13 is 7.7%.  With the 10-year U.S. Treasury note yielding about 2%, that makes stocks look very attractive.

This is a faulty comparison for two basic reasons.  One is practical.  The Fed Model has not worked consistently over significant market history.  For example, interest rates in Japan early in the 1990's were basically zero, which of course made stocks look extremely attractive.  But stock prices declined over the next twenty years for a loss of about 70%.

Two, the return on stocks is not the earnings yield.  It is the dividend yield plus dividend growth, plus changes in valuation (p/e increases or decreases).  In addition, there are problems in using "forecast operating earnings," which are not audited and not in accordance with Generally Accepted Accounting Principles.  Real earnings are net income (after supposedly extraordinary charges for restructuring, e.g.).  Also, forecast operating earnings are almost always higher than earnings actually turn out to be, since Wall Street analysts tend to be too optimistic in their forecasts.  In addition, using next twelve months earnings when profit margins are perhaps at their peak produces high--maybe even peak earnings for this cycle--and reduces the p/e (and increases the earnings yield).  The Schiller p/e uses average earnings over the last ten years to smooth out the effects of the business cycle.  It currently is 25, which would give an earnings yield of 4%, not 7.7%.

Also, does it makes sense to use the U.S. Treasury note when rates are being artificially suppressed by government policy.  The AAA corporate bond yield would seem to be a better comparison, since stocks are risky assets--as are corporate bonds.   (Though many now think that U.S. Treasury notes are very risky because of the likelihood of large price declines from rising yields in the years ahead.)  

Using lower earnings would raise the market's p/e and lower the earnings yield (to 4%).  Using corporate bond yields of 4% would make bonds look much more attractive relative to stocks than in using the "Fed Model."

I do like to compare the dividend yield on stocks to the yield on bonds and on this basis, stocks are the cheapest in about 50 years.  But that assumes that bonds are the only alternative to stocks.  Now there are various asset classes available to even individual investors.  And don't forget about cash, which is the most attractive asset class near the end of a bear market.

My advice is not to follow the Maestro's lead.  There are stocks that are still attractively priced, but after a 30% gain in the S & P over the last six months, I'd wait for a correction before making large additions to stocks.

Steve Lehman

 S & P 500:  1405

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