Thematic Thursdays: Portfolio-Balancing Effects Part 3 - Distorting the Valuation Model

In this third and final installment re the effects of the Fed's attempt to help the US economy avoid an abortion of the nascent economic recovery (as well as the dreaded outcomes articulated in St. Louis Fed president James Bullard's "Seven Faces of The Peril"), we take a look at the distortion factors to valuation models that the Fed's efforts have produced.

First the basics. Earnings and interest rates are the two principal inputs to your standard valuation model. One version of this incorporates both inputs and then reverse engineers the rate of return to match the historical long term return for large cap equities, which is approximately 11%. The model then compares the earnings yield this result produces against the 10 year US Treasury rate to get the earnings yield for stocks (which is the inverse of the P/E ratio) to the 10 year US Treasury rate spread.

Formatted in a modified version of the Fed model, here is what the data show using last Friday's closing prices*:



The answer is quite clear: even after a strong rally, with a hefty 4.28% earnings yield over the 10 year US Treasury rate, stocks are very attractive at current earnings and interest rate levels. However, if we assume that the current interest rate environment is unsupportable over the longer term, which is what assets like equities are supposed to be - long duration assets - then we get a meaningfully different outcome.

In this second example, we keep the price and the earnings at current projected levels (approx. $115 operating for the next 12 months for the S&P 500) while adjusting upward the 10 year US Treasury rate (which as the basis for our valuation model**.



As one can easily see, the spread is now substantially lower - and closer to its historical average.

We could also move the current price level for the S&P 500 to where the current price times the historical return of 11% will put the index (which would be 1831) to produce the following result.



And that result puts the spread well below its historical average.

Investment Strategy Implications

Regardless which valuation model you use, not adjusting the currently distorted interest rate input (or at least being highly aware of its valuation distortion characteristics) is the equivalent of not adjusting a generally accepted measure of risk for equities, beta, which is a backward looking metric. We aren't investing in the past anymore more than we drive a car using the rear view mirror. Therefore, investing based on valuation model outcomes using current rates of interest for long duration assets like equities seems to be naive at best and reckless in the extreme. Then again, with the hedgies and their short term comrades-in-arms operating as the dominant at the margin force in today's changed market structure, who said equities are long duration assets, anyway?

*click images to enlarge
**In the unmodified version, no adjustment to the 10 year rate is made rendering the model useless in the real world.

***

Thematic Thursdays is a product of Blue Marble Research Advisory and focuses on important global trends and themes impacting the global economy and markets and an integral part of the three-legged stool approach of Blue Marble Research.

On average, thematic issues are longer term in nature, transcending the business cycle in time and economic sector categorizations. However, many shorter term players in the financial markets use trends and themes as a staple of their investment strategy. Understanding how to incorporate thematic analysis - along with fundamental and technical analyses - is an integral part of the process that forms the three-legged stool of the analytical approach employed by Blue Marble Research Advisory.

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