There's a rule of thumb that says stocks are a bargain right now. It's called the Fed model. It's simple, it has a famous name on it, and it worked for years. Spencer Jakab, in Tuesday's Heard on the Street column, asks whether it's just wishful thinking. His answer is mostly yes, and he makes a good case.
Here's the whole model in one sentence. Take the S&P 500's expected profits for the next year, divide by its price, and compare that number with the 10-year Treasury yield. That first number is called the earnings yield. Right now it's 5.3%, by FactSet. The 10-year note pays 4.92%, the column says. It closed Monday, Nov. 2 at 4.893%. Stocks yield more, so the model says own stocks.
Wall Street strategist Ed Yardeni found the idea buried in a 1997 Federal Reserve report and gave it the name. People tied it to Fed Chairman Alan Greenspan. He never backed it. In fact he had just warned about “irrational exuberance” in tech stocks. The model looked right through the late 1990s. Then the market peaked in early 2000 and the model's fans learned what it had missed. Cliff Asness of AQR wrote that it has “the appearance, but not the reality, of common sense.” Yardeni himself stepped back from it. That was truer still once the Fed was holding bond yields down on purpose. Then in August he wrote that it might be working again.
Where the math goes wrong
The flaw is in the comparison. A bond yield includes inflation. An earnings yield doesn't. And today's earnings sit on near-record profit margins, which don't last forever. Robert Shiller, the Nobel economist, fixes both problems. He uses long-run average earnings, adjusted for inflation, against inflation-adjusted bond yields. He calls the result the excess CAPE yield. By that gauge, stocks have only rarely been this expensive. They sit about where they were when Greenspan gave that famous warning. The Journal's chart covers 50 years. Today's reading is near the low end.
Our read
This is an Investments/Risk · IN04 story with a Fixed Income · IN02 lesson inside it. A 10-year Treasury near 4.9% is real competition for stocks. A few years ago cash and bonds paid almost nothing, so stocks won by default. That's over. One flattering yardstick is no reason to take more risk. In our model books the safe money sits in Treasury bills and floating-rate paper, bonds whose interest resets with short-term rates. That's SGOV in 49 books and USFR in 14. We avoid long bonds (TLT in 4 older books, nothing added). Nothing added, nothing trimmed. We hold.
Here's your check this week. Find the bond or cash side of your own plan and look at what it actually pays. A 13-week Treasury bill sold Monday at 4.040%. If your 401(k) stable-value fund or money market pays well under that, ask why. Know that number before anyone shows you a chart that says stocks are cheap. A sunny forecast isn't a reason to leave the umbrella at home.