Asset Valuation Allocation Models
R e s e a r c h
July 30, 2002
Asset Valuation & Allocation Models
Dr. Edward Yardeni (212) 778-2646 ed_yardeni@prusec.com Amalia F. Quintana (212) 778-3201 mali_quintana@prusec.com
- Introduction I. Fed’s Stock Valuation Model How can we judge whether stock prices are too high, too low, or just right? The purpose of this weekly report is to track a stock valuation model that attempts to answer this question. While the model is very simple, it has been quite accurate and can also be used as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after reading that the folks at the Federal Reserve have been using it. If it is good enough for them, it’s good enough for me. I dubbed it the Fed’s Stock Valuation Model (FSVM), though no one at the Fed ever officially endorsed it. On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board, famously worried out loud for the first time about “irrational exuberance” in the stock market. He didn’t actually say that stock prices were too high. Rather he asked the question: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions….”1 He did it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of the market’s exuberance. Apparently, they did so and it was made public, though buried, in the Fed’s Monetary Policy Report to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on July 22, 1997. 3 The Fed model was summed up in one paragraph and one chart on page 24 of the 25page document (see following table). The chart shows a strong correlation between the S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E) to the price index for the S&P 500 companies (P), using 12- month-ahead consensus earnings estimates compiled by Thomson Financial First
July 30, 2002
Asset Valuation & Allocation Models
Dr. Edward Yardeni (212) 778-2646 ed_yardeni@prusec.com Amalia F. Quintana (212) 778-3201 mali_quintana@prusec.com
- Introduction I. Fed’s Stock Valuation Model How can we judge whether stock prices are too high, too low, or just right? The purpose of this weekly report is to track a stock valuation model that attempts to answer this question. While the model is very simple, it has been quite accurate and can also be used as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after reading that the folks at the Federal Reserve have been using it. If it is good enough for them, it’s good enough for me. I dubbed it the Fed’s Stock Valuation Model (FSVM), though no one at the Fed ever officially endorsed it. On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board, famously worried out loud for the first time about “irrational exuberance” in the stock market. He didn’t actually say that stock prices were too high. Rather he asked the question: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions….”1 He did it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of the market’s exuberance. Apparently, they did so and it was made public, though buried, in the Fed’s Monetary Policy Report to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on July 22, 1997. 3 The Fed model was summed up in one paragraph and one chart on page 24 of the 25page document (see following table). The chart shows a strong correlation between the S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E) to the price index for the S&P 500 companies (P), using 12- month-ahead consensus earnings estimates compiled by Thomson Financial First