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Sept. 20, 2011, 12:01 a.m. EDT
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” I have some very bullish news to report.
But it comes with a catch "” a very big one, in fact.
First, the bullish news: One of the most popular market timing models of recent decades is showing the stock market to be more undervalued now than at any other time in decades.
Now the catch: The model is significantly, perhaps fatally, flawed. It's not clear you should pay it any attention.
I'm referring to the so-called Fed Model. Though it has existed in one form or another for decades, it grew to great notoriety in the late 1990s "” and took on its current name "” on the basis of some cryptic comments contained in a single paragraph in the Fed's July 1997 monetary policy report to Congress.
The Fed Model holds that the stock market is undervalued whenever the 10-year Treasury note is less than the stock market's earnings yield (which is the ratio of expected earnings over the next 12 months to the stock market's level). According to Standard & Poor's, for example, the S&P 500 /quotes/zigman/3870025 SPX +1.02% is estimated to earn around $105 per share over the next four quarters "” equal to an earnings yield of 8.7%, based on where the market is today.
The 10-Year Treasury note yield /quotes/zigman/2755237 XX:TNX +0.62% , in contrast, currently stands at 1.94%, or nearly 7 percentage points less. According to a recent analysis by JPMorgan Funds, this is the widest this spread has been in favor of stocks since the 1950s.
David Kelly, chief market strategist at JPMorgan Funds, was quoted as saying that this amounts to a "screaming buy" for stocks.
"It's bordering on insanity," he added.
From my point of view, however, what's insane is that anyone gives the Fed Model the time of day. It has no sound theoretical basis. And its track record is dismal.
According to Finance 101, the stock market's earnings yield is supposed to be higher than Treasury notes, since stocks are riskier than bonds. What the Fed Model is interpreting as evidence that the stock market is undervalued is really nothing more than a reflection of stocks' relative riskiness.
In other words, the Fed Model is designed to almost always show stocks to be undervalued. Indeed, the Fed Model was bullish on stocks in October 2007, at the very top of the stock market. It still was bullish in September 2008, right before Lehman Brothers went bankrupt and the stock market went over a cliff. And it is bullish today.
It's not quite a bullish stopped clock, but it's close. No wonder Wall Street loves it.
According to an econometric analysis by mutual-fund manager John Hussman (of the Hussman Funds), the Fed Model since 1948 explains "just 3% of the variation in S&P 500 total returns over the following year, 2% of the variation in seven-year returns, and just 1% of the variation in subsequent 10-year returns." ( Read Hussman's study. )
This doesn't mean the stock market is destined to fall in coming months, I hasten to add. It may very well rise, just as the Fed Model's adherents are predicting.
My point is that, however, if the market does rise, it will have nothing to do with that Fed Model.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD... Expand
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now. Collapse
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