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Fundamental Valuation

What fundamental measures of business success best indicate the value of individual stocks and the aggregate stock market? How can investors apply these measures to estimate valuations and identify misvaluations? These blog entries address valuation based on accounting fundamentals, including the conventional value premium.

50-Year Fed Model Meme?

Is the Fed Model a useful market timing tool? In their March 2005 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: Keep Reading

One Up on the Fed Model?

In their June 2003 paper entitled “A General Theory of Stock Market Valuation and Return”, Christophe Faugere and Julian Van Erlach contend that past stock returns are overstated and develop a market valuation formula that out-fits the Fed Model. Specifically, they show that: Keep Reading

Earnings Yield-Interest Rate Spread

In his May 2002 paper entitled “Market Timing Strategies that Worked”, Pu Shen evaluates the effectiveness of the spreads between the S&P 500 index earnings yield (the earnings/price ratio or E/P) and the yields on 10-year Treasury notes (T-note) and 3-month Treasury bills (T-bill) as market timing indicators. By constructing “horse races” between switching strategies that call for investing in the stock market index unless spreads are lower than predefined thresholds during 1970-2000, he concludes that: Keep Reading

Classic Paper: Piotroski’s Efficient Value Investing

We occasionally select for retrospective review an all-time “best selling” research paper of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). In his January 2002 paper entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”, Joseph Piotroski applies a simple accounting-based fundamental analysis strategy to a broad portfolio of high (top 20%) book-to-market firms to enhance returns. His stock scoring system (FSCORE) consists of nine binary signals based on profitability and value-specific financial measures (see the list below). Using stock returns and fundamentals for a broad sample of U.S. stocks during 1976 through 1996, he finds that: Keep Reading

Fed Model: Predictive or Not?

Many investors monitor the Fed Model, based on the relationship between the earnings yield of stocks and the bond yield, for long-term stock market timing signals. Does this model really work? Notable contrary arguments are found in the December 2002 paper entitled “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns” by Clifford S. Asness and the 2004 paper entitled “A Tactical Implication of Predictability: Fighting the Fed Model” by Roelof Salomons. These two papers present similar analyses and conclusions, as follows: Keep Reading

Is Irrational Exuberance Over Yet?

In the early 2001 update of their 1998 paper entitled “Valuation Ratios and the Long-Run Stock Market Outlook: An Update”, John Campbell and Robert Shiller focus on mean reversion of two valuation ratios, price-earnings and dividend-price, as key predictors of future stock market performance. The authors determine that mean reversions of these ratios occurs through stock price changes, not earnings or dividend changes. At the time of the update, they note that “these ratios imply a stronger case for a poor stock market outlook than has ever been seen before.” Keep Reading

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