Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Federal Reserve officials were widely expected to raise their target for benchmark interest rates on Wednesday, and they didn't disappoint. In doing so, they also instantly made U.S. stocks more expensive, according to one measure of valuations.

The so-called Fed model says that U.S. stocks are cheap when their forward earnings yield is greater than the yield on 10-year Treasuries, and vice versa.

For example, analysts estimate that earnings per share for the S&P 500 will be $130 over the next year, and the S&P 500 closed at 2,365 on Tuesday. That put the forward earnings yield of the S&P 500 at 5.5 percent ($130 divided by 2,365). The yield on 10-year Treasuries, by comparison, is just 2.5 percent. Ergo, U.S. stocks  are cheap.

Bargain Basement
According to the Fed model, stocks have been exceedingly cheap since the 2008 financial crisis
Source: Bloomberg

Now, with Treasury yields expected to rise along with the fed funds rate, that gap will narrow, making stocks less attractive.

The Fed model may seem sensible at first glance, but look deeper and cracks start to appear. First, it relies on analysts’ estimates of future earnings, which are wildly unreliable -- particularly during turning points in the business cycle. Analysts, for instance, overestimated earnings by an average of 34 percent in the aftermath of the dot-com bubble in 2001, and by an average of 74 percent as the economy unraveled during the financial crisis in 2008.

Anybody's Guess
Analysts' earnings estimates have been unreliable, particularly during turning points
Source: Bloomberg
Note: Analysts' estimate is BEst EPS, next four quarters.

More recently, analysts have overestimated earnings by an average of 12 percent since 2016, which means that the earnings yield baked into the Fed model has been overstated by at least 0.6 percentage point -- a significant sum in a low-yield environment. And if corporate profits take a tumble unforeseen by analysts, the earnings yield could be dramatically overstated.   

Even more problematic is the fact that the Fed has de facto control over 10-year Treasury yields. Consider that the correlation between the fed funds rate and the yield on 10-year Treasuries has been a near-perfect 0.91 since July 1954. Treasury yields, in other words, move higher and lower along with the fed funds rate.

Strong Bonds
The fed funds rate has historically been highly correlated with 10-year Treasury yields
Source: Federal Reserve

 The odd result is that the Fed model gives U.S. central bankers magical powers to decree whether stocks are cheap or expensive without regard to price and fundamentals -- the foundations of any thoughtful valuation. When Fed officials lowered the fed funds rate from 6.5 percent in 2000 to under 2 percent in 2001, for example, stocks became instantly more attractive according to the Fed model even though the earnings yield had barely budged. The same thing happened again when the Fed adopted its zero-interest-rate policy in 2008.  

 These problems haven't bothered devotees of the Fed model in recent years. The S&P 500 has returned 18.2 percent annually since the trough of the financial crisis in March 2009 through February, including dividends. Investors have been well rewarded for conflating low interest rates with cheap stock valuations.

All About the Fed
Devotees of the Fed model have been handsomely rewarded since the 2008 financial crisis
Source: Bloomberg
Note: Indexed to 100.

But those same devotees now have cause for concern because, one way or another, it seems as if the Fed model is pointing to less attractive stock valuations ahead. Today’s hike was just the first in a series the Fed plans to implement over the next three years. If the economy continues to cooperate, the 10-year Treasury yield is likely to approach 5 percent. On the other hand, if the economy stumbles and derails the Fed’s plans, even the most stubbornly optimistic analysts will be forced to lower their earnings estimates.

So whether Treasury yields rise or earnings yields decline, the Fed model has a new message for its followers: The era of cheap stocks is over. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net