Raise your hand if you remember the so-called "Fed Model" that was so popular in the 1990's. Now put your hand down, because you are reading this over the internet and probably look pretty silly. For those of you who did not raise your hand, here is a little refresher course before we get started.
The term "Fed Model" was coined by Ed Yardeni when he referenced research the Federal Reserve conducted on the equilibrium between the yield on 10 year Treasuries and the earnings yield of the S&P 500 index. Simply stated, the Fed model suggests that the yield on 10 yr Treasuries should be equal to the earnings yield on the S&P 500. The earnings yield is simply the P/E ratio upside down or earnings divided by price. While rarely at "equilibrium" the Fed model can be used to compare the relative value of Treasuries to equities. When the earnings yield on the S&P 500 is greater than the 10 year yield, the Fed model suggests investors should sell Treasuries and buy Equities. The difference between the yields is referred to as the risk premium.The obvious flaw in the model is that it assumes investors are rational and that the only factor considered when investing is the trade-off between treasuries and equities. Books can and have been written on the Swiss Cheese like structure of this model, but what I want to focus on is the implied earnings that can be derived from the model.
In calculating the risk premium we need three variables: S&P 500 earnings, 10 year yield, and the S&P price. At all times we can observe both the S&P 500 price and the 10 year yield, therefore we can infer the earnings that market participants expect at any given time and any given risk premium, by using the formula (Risk Premium +10 Year Yield) x S&P 500 Price = Implied Earnings. The following chart was constructed using an S&P 500 price of $745.
The "You are Here" figure is an implied earnings of $48.43 per share for the S&P 500. It was calculated by using the year end S&P earnings as compiled by NYU and the current 10 year Treasury yield. The risk premium was calculated to be ~3.5%, therefore (3.5%+3%)x$745 = $48.43. I used these numbers in an attempt to hit a moving target and give reference point for analysis.
Looking back at historical risk premia we can see that the highest level was achieved during the recession of the 1970's. That peak was a risk premium of 6.08% in 1973. If we assume that investors will require at least a 6% premium to invest in stocks then we can calculate that investors are implying eps of $67.05, given current 10 year yields. According to S&P, earnings estimates for 2009 are $66.61. Using forward eps of $66.61 the current PE is 11.18 (S&P 500 $745). Using the Fed model we can calculate estimated targets for the S&P 500. If we assume the earnings estimates are accurate (BIG assumption) then the S&P 500 is fairly valued at $745. However, if we use the "you are here" figures, which represent current conditions then the S&P 500 target is $538.48.
Calculating exact targets in the financial markets can be foolhardy, that is why I present these targets simply as a framework by which to analyze the current equity markets. Perhaps the discrepancy between estimates and implied earnings is at the root of the volatilty, I will let you decide…
Dislcosure: I am short several S&P sectors.