Blog - Investing Notes

September 17, 2008 - Update: Real Earnings Yield Model Scenarios

For this sensitivity analysis of the short-term Real Earnings Yield (REY) model, we use the version based on core inflation rate because this version has been more accurate than that based on the total inflation rate in fitting the historical S&P 500 index over the past few years. We consider four S&P 500 operating earnings scenarios and two core inflation rate scenarios, with a tilt toward pessimistic inputs. Using projections through the third quarter of 2009, we find that...

The following chart depicts various REY model projections, as follows:

• The "As Forecasted" scenario reflects the latest available bottoms-up S&P 500 operating earnings forecast from Standard and Poor's and our current core inflation projection.
• The "Earnings 20% Below Forecast" scenario assumes that currently forecasted S&P 500 operating earnings for the second quarter of 2008 and all subsequent quarters are 20% too high.
• The "Earnings 10% Below Forecast" scenario assumes that currently forecasted S&P 500 operating earnings for the second quarter of 2008 and all subsequent quarters are 10% too high.
• The "Earnings 10% Above Forecast" scenario assumes that currently forecasted S&P 500 operating earnings for the second quarter of 2008 and all subsequent quarters are 10% too low.
• The "Core Inflation to 3%" scenario assumes that 12-month trailing core inflation rises linearly from 2.52% to 3.00% over the next 12 months.

Obviously, wide-ranging assumptions result in wide-ranging model outputs.

Note that in the REY model, the inflation rate essentially sets the aggregated market price-earnings ratio. Investors have been somewhat less sensitive to core inflation rate fluctuations the past few years than over a longer sample period. They seem instead to be more than usually focused on earnings. A persistent trend up or down could cause investors to elevate attention to the inflation rate, thereby amplifying the downward effect for the "Core Inflation to 3%" scenario (driving the the aggregate price-earnings ratio down).

In summary, this Fed model-like stock market valuation forecast is currently much more sensitive to beliefs about future corporate earnings than beliefs about future inflation.

For related research, see Blog Synthesis: Gunning for the Fed Model?. See our blog entries of 6/25/08 and 3/13/08 for prior REY model scenario analyses. In both analyses, something similar to the worst case earnings assumption happened.