Friday, May 11, 2007

Uncertainty – The One Constant in a Global Environment

What does it say when a gaggle of economists can’t get a monthly domestic number correct like the April retail sales? When you combine this morning’s April retail sales number with the just concluded 1Q07 earnings season, the issue that leaps out is unpredictability. This unpredictability factor is key to valuation models as the Fed Model shows on today’s blog.

Investment Strategy Implications

The Fed Model (see updated model on May 23rd blog entry) illustrates the risk adjustment process that reflects uncertainty. As noted earlier this week, an 80 to 100 basis point upward adjustment to the capitalization rate of the 10-year US Treasury (which equals the downward adjustment to the P/E ratio) has been the average risk premium throughout most of this bull market. A reduction of that premium implies an increase in risk taking.

As much as bullish investors would wish otherwise, today’s world is a highly uncertain one. So, when forecasts go awry with such regularity, a substantial reduction in the risk premium seems most unwarranted.

Have a good weekend.

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