Blog - Investing Notes
November 12, 2004 –
50-Year Fed Model Meme?
Is the Fed Model a useful market timing tool? In their
March 2004 paper entitled "The Market P/E Ratio: Stock Returns, Earnings, and
Mean Reversion", Robert Weigand and Robert Irons investigate whether
very high price/earnings (P/E) ratios foreshadow poor future stock market
performance. Using data over the very long period from 1881 to 2002,
they find that:
- At high starting P/E ratios (21 and above), stocks
deliver 10-year real returns in line with their long-term historical
average. These high P/E periods are associated with the highest rates
of real earnings growth on record.
- Prior to 1960, the P/E ratio reverts to its long-term
mean of 14 with almost predictable regularity. Since 1960 (approximately
the time that investors began using the Fed Model), market E/P ratios and
bond yields have tracked closely. There may be no reason to fear bear
market returns expected to accompany high P/E ratios.
- On a note of caution, investors could abandon their
belief in the Fed Model when interest rates begin rising, decoupling
the longstanding relation between market earnings yields and interest
rates.
In summary, the Fed Model has worked pretty well
starting about 1960, with interest rates since playing a key role in
stock valuation.
For a collection of recent research related to the Fed
Model, see Blog
Synthesis: Gunning for the Fed Model?.
