Just recently my colleague Jesse Felder penned an excellent piece discussing the use of the “four most dangerous words”
in investing: “this time is different.” The whole article is a must read, but he hit on a particular point that has become a mantra for speculative investors as of late:
“In other words, valuations don’t matter as much as they did in the past because ‘this time is different’ in that interest rates are so low.”
The basic premise of the interest rate/valuation argument has its roots in the “Fed Model” as promoted by Alan Greenspan during his tenure as Federal Reserve Chairman.
The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa. In other words, disregard valuations and buy yield.
Let me warn you now this will not end well.
There is an important disconnect that needs to be understood.
You receive the income from owning a Treasury bond, however, there is NO tangible return from the earnings yield.
For example, if I own a Treasury bond with a 5% coupon and a stock with a 8% earnings yield, if the price of both assets don’t move for one year – my net return on the bond is 5% while the net return on the stock is 0%.
Which one had the better return?
Yet, analysts keep trotting out this broken model to entice investors to chase an asset class with substantially higher volatility risk and lower returns.
It hasn’t been just since the turn of the century either. An analysis of previous history alone proves this is a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50’s and 60’s the model actually worked pretty well as economic growth was strengthening.
Then, beginning in 1980, as Reagan and Volker set out to break the back of high-interest rates, the model no longer functioned. During the biggest bull market in the history of the markets, you would have sat idly by in Treasuries and watched stocks skyrocket higher.
However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost all of your gains during the crash of the markets in 2008.
