Wednesday, June 20, 2007

Curiously Oscillating Around Fair Value

Is it a coincidence that the market appears to be oscillating around fair value?

Using my updated modified Fed Model (see table to your left), the expected return for stocks has traded right around 0% for the past several weeks, thanks to the combination of higher stock prices and higher interest rates. Coincidence? Maybe. However, since reaching these levels, the market has largely stagnated despite several outstanding earnings results reported thus far, not much in the way fearful pre-announcements, and expectations that 2Q07 GDP growth will rebound to a 4%+ number. Coincidence? Maybe. Or perhaps investors are toying with the idea of moving into overvalued territory, a zone it hasn’t occupied since the bubble days.

The bulls would argue that adding 90 basis points to the base Fed Model* is a mistake and that a lower risk premium/higher capitalization rate resulting in a higher valuation level is justified. I guess that's what makes it a market. What cannot be argued, however, is the need for a valuation guidepost in which investors can play their “What if?” scenarios.

Of course, one can debate whether any valuation model makes sense, even in the most predictable of times (which, despite trends like the “Great Moderation”, these are not). This is understandable, given the highly subjective nature of valuation. Nevertheless, we investors are compelled to render such view. No getting around this fact of investing life. Therefore, I invite you to consider what your Fed Model inputs might be and whether fair value has been reached.

*The extra 90 basis points is the average risk premium/capitalization rate added throughout this bull market. This was noted in last Friday’s Financial Times article in which I was quoted (see excerpt in left column below).

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