Review: The Fed Model’s Flawed Valuation

A year ago (Feb ‘08), I tried to explain why the (so called) Fed Model was worthless as a measure of valuation:

“Note that the formula contains two variables: While it is commonly described as a way to evaluate when stocks are over- or under-valued, the other variable in the formula is the forward S&P500 earnings consensus. SPX prices and the 10 year yield are the knowns, while BOTH valuation and forward earnings estimates are the unknowns.

Thus, the Fed model today might be telling you either of two things: When equities are undervalued — or when consensus earning estimates are simply too high.”

Surprisingly, there was lots of pushback on that. I didn’t get why (other than people talking their books). This is not complex — its a basic analysis of knowns versus variables in a simple formula. What the forward earnings will be is an opinions, not a fact.

Plug and chug led to this conclusion:

So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings  explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half.

Anyway, think back as to which analysts/fund managers/talking heads who used the Fed Model as their justification for claiming equities were cheap 1 or 2 years ago and buying them; put them on your DO NOT CALL/IGNORE list. They are clueless dolts who will lose you money if you listen to them . . .

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Previously: The Flawed Fed Valuation Model (February 2008) http://www.ritholtz.com/blog/2008/02/the-flawed-fed-valuation-model/

Cheapest Stocks in Two Decades based on Flawed Fed Model (April 2007) http://www.ritholtz.com/blog/2007/04/cheapest-stocks-in-two-decades-based-on-flawed-fed-model/

Time-Tested Signs of an Overvalued Market (March 2004) http://www.ritholtz.com/blog/2004/03/time-tested-signs-of-an-overvalued-market/


Originally published at The Big Picture blog and reproduced here with the author’s permission.