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Fed Model Versus P/E Model

| | Posted in: Fundamental Valuation

Conventional wisdom says that high market P/E ratios forecast negative future stock returns. In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion,” Robert Weigand and Robert Irons to test this conventional wisdom. Using data back to the 1880s, they pit the Fed Model against the P/E mean reversion model to determine which one better explains stock market behavior. They find that:

  • There is a significant break in the stock return-P/E relationship at P/E ratios of 21, above which real earnings growth is well above average and 10-year real stock returns are at the historical average.
  • The behavior of the market P/E changes abruptly about 1960, shifting from stationary to nonstationary as the market earnings yield (E/P) develops a strong correlation with the 10-year Treasury note (T-note) yield.
  • Investor use of the Fed Model allows the market P/E to persist above trend indefinitely; it is no longer mean-reverting.
  • Especially since 1960, changes in the market P/E, rather than the level of the market P/E, correlate closely with expected earnings growth.
  • Both the Fed Model and the P/E reversion model predict declines in market P/E, the former because of rising interest rates during economic expansion and the latter because of mean reversion.
  • Returns on U.S. equities over the next decade will be low (about 1.3% real or 3.8% nominal annual returns) but positive.
  • The extremely high market P/Es of the 1990s, the duration of those high P/Es, the historically low stock dividend yield and persistently overoptimistic earnings forecasts of analysts justify investor wariness.
  • As long as investors believe in the Fed Model, the market P/E is a slave to nominal interest rates. Investors have more to gain from equating E/P and interest rates when rates are falling. Since the Fed Model is likely driven more by cognitive error than economic fundamentals, investors may abandon the model as interest rates rise, negatively influencing equity returns.

In summary, the Fed Model better describes the behavior of the market P/E over the past forty years than does a mean-reverting model.

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