According to MarketWatch contributor Mark Hulbert, the current market conditions might appear unfavorable for the stock market based on the Federal Reserve model. However, he suggests that investors need not worry too much as this model has limited practical value. Despite this, there might still be valid reasons for investors to be concerned about the market's future.
The Federal Reserve model, which compares the equity earnings yield (inverse of the P/E ratio) of the stock market to the 10-year Treasury yield, indicates unfavorable conditions when the treasury yield surpasses the earnings yield. Currently, the S&P 500 (SPX, Financial) earnings yield stands at 3.90%, while the 10-year Treasury yield is at 4.46%, marking a significant negative margin not seen since the 2008-2009 financial crisis.
Hulbert points out that the model's methodology, which compares real equity earnings with nominal Treasury yields, is inherently flawed. From an analysis of data dating back to 1871, he deduced that the ability to predict stock market returns is stronger when relying solely on the earnings yield, rather than the Fed model's adjusted calculation.
The model's current "alarm" might suggest an overvaluation of the U.S. stock market, but Hulbert argues that this might not be accurate. The model essentially compares apples to oranges—real stock earnings versus nominal bond yields which do not account for inflation changes. In high inflation times, corporate earnings usually grow faster, affecting the model's accuracy.
While the Fed model might be flawed, it doesn’t rule out the possibility that U.S. stocks could be overvalued. Investors might have other reasons or evidence supporting the notion of an overvalued market.
