In the 1990s (boy, does that seem a long time ago!), a model for evaluating the stock market and determining whether it was over or under priced became popular. It was called the "Fed Model" (I think Ed Yardeni, a prominent market strategist, came up with the name), and it involved comparing the earnings yield of a stock index with the yield on 10 year treasuries. You haven't heard much about it lately, and I think that the reason is that it would produce results which would be widely viewed as absurd.
For example, Deutsche Bank has predicted that QE will drive the 10 year treasury rate to 2%. Under the Fed Model, this would be consistent with an earnings yield of 2% or a PE of 50. Taking Barron's recent projection of 2011 Dow earnings ($932) and multiplying by 50 produces a predicted index price of 46,600. I do not believe that there is anyone not under the influence of a controlled substance who seriously thinks we will reach that level in the foreseeable future, if ever.
The Fed Model drew a number of critics - some proposed that a rate of return on inflation indexed bonds be used instead. Bear Stearns (remember them?) had a formula using predicted inflation and the spread between treasuries and corporate bonds(I forget which rating they used) to capture risk aversion. One group of economists argued that interest rates were totally irrelevant to stock market valuation because, while under discounted earnings stream or dividend stream analysis, low interest rates tend to increase valuations because a lower discount rate is applied, this factor is completely offset because low interest rates also mean that the expected level of nominal earnings and nominal dividends are decreased proportionately so that the valuation stays the same regardless of prevailing interest rates(I have oversimplified the argument a bit, but I believe I have captured its essence).
It's intuitively hard to accept the notion that interest rates are completely irrelevant to stock market valuation. First of all, dividend paying stocks are an alternative to bonds and become more attractive as bond yields decline. Critics would argue that dividends are higher than interest payments because of an expectation that dividends will be reduced. But this is somewhat hard to accept, especially with respect to electric utility stocks (the Dow Utility Index dividends continued to increase - although very slowly - through the recent financial crisis) and recession-resistant stocks like Procter&Gamble (PG), Johnson&Johnson (JNJ), Coke (KO), WalMart (WMT), McDonald's (MCD) etc.
It is also the case that low interest rates on corporate debt create the opportunity for stock/bond arbitrage as corporations can borrow money and use the funds to buy back their own stock. This seems to be occurring now at an increasing rate. In this regard, it should be noted that a corporation will increase its per share earnings as long as the after tax interest rate on the bonds is less than the earnings yield on its stock. Thus, a company which borrows funds at an after tax cost of 2% (not uncommon today) will increase its per share earnings as long as it pays a price for its own stock which is below a PE of 50. The lower the PE, the bigger the increase in per share earnings created by the buy back. A similar analysis can be done of acquisitions for cash; as long as the earnings yield of the acquired firm is above the interest rate on the borrowed funds, the acquisition will increase net earnings. It should be noted that the viability of these two mechanisms for closing the gap between interest rates and earnings yields depends not upon Treasury interest rates but upon the interest rates on corporate debt.
This has led me to a few conclusions. I think that the yields on corporate debt may be more relevant to stock prices. Think of late 2008, Treasury yields were very low, but corporate debt instruments were enormously discounted as yield spreads reached record levels. Equity valuations were very low and that is not surprising. Risk aversion was enormous and it affected both equities and corporate bonds. The equity market improved as yield spreads declined. Looking at the situation today, yield spreads for high yield bonds are still relatively high although they have declined enormously from the levels of early 2009. The high yield spreads reflect investor risk aversion, and this would be expected to depress stock market valuations although not as seriously as in late 2008.
What has surprised me is that the assets which appear to be most overpriced are the safest bonds (treasuries and AAA corporate) and the riskiest equities (tech startups, highly leveraged financial institutions, etc.). This has led me to favor the safer stocks (consumer staples and electric uitlities) which should be trading at a substantial premium in this risk averse environment and the riskiest bonds which are underpriced relative to the overall debt market.
The investment community really needs some intelligent analysis of this stock/bond valuation issue. It is obvious that the Fed Model is obsolete, but I also believe that interest rates have some relevance to stock prices. Hopefully, some smart academics will explain all of this to the rest of us while we try to navigate these treacherous waters.
Author's Disclosure: Long JNJ, KO, PG, WMT, MCD, high yield bonds
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