This week’s chart revisits former Federal Reserve (Fed) Chair Alan Greenspan’s favorite stock market valuation tool — the so-called “Fed Model.” The “Fed Model” measures the relative value between stocks and bonds by comparing the 10-year Treasury yield with the S&P 500 earnings yield — the reciprocal of the price-to-earnings (P/E) ratio. This tool factored heavily into Chair Greenspan’s infamous pronouncement in December 1996 that an overvalued stock market resulted from irrational exuberance. Greenspan’s bearish call initially turned out to be very wrong (the S&P 500 would more than double by March 2000), but he was partially vindicated when the tech bubble burst. Greenspan would later grade this market forecast a “C.”
During the past two decades, the interest rate environment has been very different from the 1990s when the “bond vigilantes” enforced fiscal discipline on U.S. policymakers through the buying and selling of bonds. Since 2000, 10-year Treasury yields have averaged exactly one-half the rate levels during the 1990s — 3.33% versus 6.66%. Not surprisingly, as 10-year yields have fallen, the “Fed Model” has generally favored stocks over bonds. By 2017, persistently low interest rates reached a point where Greenspan would label the bond market as the next bubble about to burst.
The “Fed Model” scales tilted even more toward equities being relatively attractive as the 10-year Treasury yield moved into record-low territory this year. The fall to record-low yields was not the result of overexuberance among bond investors, but rather the economic damage created by the coronavirus pandemic and the new and extraordinary monetary stimulus measures taken to ease the damage.
The Fed’s promise of easy money for years into the future does increase the risk of creating the next market bubble, according to Robert Kaplan, president of the Dallas Federal Reserve Bank. President Kaplan’s dissenting vote at last week’s Federal Open Market Committee meeting was made to maintain more rate-setting flexibility after the economy has weathered the pandemic. Kaplan’s dissent is a sign that the challenges for monetary policymakers may get even more complicated once accommodation needs are pulled back and the market — not the Fed — returns to setting interest rates.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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