Feb 20/15 – The trouble with models

2015-02-20 10am EDT  |  #Fed model

I met my wife in university, so I never had a big dating stage. Not only that, I was never tall, handsome or rich enough to date models. But I have a buddy or two that used his success on Bay Street to parlay into various relationships with assorted models of varying fame. And the funniest part about all these guys dating models? Not a single one of them was ever happy. Either they were sick of the constant stream of diet cokes and cigarettes, or they were complaining about their girlfriends being as dumb as a sack of bricks (I apologize to all the smart models out there, and I am sure there are a couple, but I doubt they are reading my letter). There was even a Bay Street salesman that had managed to marry a Playboy bunny. I had heard the story through the grapevine, but I had never met the guy. One night I ended up out on the town drinking with him. He had recently gotten divorced, so I was hesitant to ask too many questions. But how often do you meet a guy who married a Playboy bunny? And I am not talking just some picture from The Girls of the Big Ten spread – I am talking about full on Miss March playboy bunny. So I decided to try talking about the Playboy mansion as a sort of neutral not-about-his-ex-wife question.

“Did you ever get a chance to visit the Playboy mansion?” I asked.

“Yup,” he slurred back, “I was there a couple of times.”

“What’s it like?” I responded.

“Well, everyone has this image of it being this Shangri-La with half clothed beauties running around this wonderful mansion,” he explained, “but it’s not.”


“Yeah, it’s actually a complete shit hole. It’s dirty, run down, full of bimbos trying to sleep their way into the magazine. I wouldn’t go into the grotto without a full on Hazmat suit. And the Hollywood scum that hang out there are complete jack asses. I spent the whole time trying to pry Jeremy Piven away from my wife. Even though he knew we were married, he just kept trying, and trying. What an asshole.”

“Oh, that’s crappy,” I responded. After all, what do you say to a guy who has just ruined your teenage dream about the coolest place in the whole world? But I couldn’t help thinking; what else did he expect from Ari?

So I never regret not dating models because I have learned; they never live up to the image we have in our mind.

And interestingly enough, many economic models are just as prone to not living up to their expectations. This is especially true as Central Banks throughout the world have pushed short term rates to zero and below.

I have written about this too much, but the absurdity of entire yield curves shifting below zero, or Central Banks monetizing through S&P 500 futures is just asinine. The whole monetary system has crossed the streams.

How can you price any risk asset when the risk free rate is zero, or even lower? Let’s take the so called “Fed Model” for forecasting equity prices. Here is a brief history of this model from Investopedia:

On July 22, 1997, The Fed’s “Humphrey-Hawkins Report” introduced a graph of the close relationship between long-term Treasury yields and the forward earnings yield of the S&P 500 from 1982 to 1997.

Shortly thereafter, in 1997 and 1999, Ed Yardini at Deutsche Morgan Grenfell published several research reports further analyzing this bond yield/stock yield relationship. He named the relationship the “Fed’s Stock Valuation Model”, and the name stuck.

The Fed Model is a valuation methodology that states there is a relationship between the forward earnings yield of the stock market (typically the S&P 500 index,) and the 10-year Treasury bond yield to maturity (YTM). The yield on a stock is the expected earnings over the next 12 months divided by the current stock price and is symbolized in this article as (E1/PS). This equation is the inverse of the familiar forward P/E ratio, but when shown in this yield form it highlights the same concept as the bond yield (YB) – that is, the concept of a return on investment.

Now this model works half decently when yields are in the normal range. But think about what happens when yields fall to zero (or even negative). As the yield falls closer to zero, the price you should be paying for equities rises towards infinity.

And what about pricing equities when bonds are negative yielding? How the hell do you do that?

In fact, there is probably some model out there why bonds should never trade at a negative yield. Why would anyone ever buy a bond that has a guaranteed negative yield? (I know the answer, but it still amazes me.)

If you are a European equity analyst how do you apply a discount rate to the future cash flows and earnings when the rate is negative? And the idea of fudging it by using the corporate bond rate has been tossed out the window as even corporates have ventured down below zero recently.

The foundation that lays at the heart of most of these models is the risk free rate. As this rate has been distorted to absurdly low levels, it has made many of these models useless.

Let’s take the S&P 500 for example. It is trading around 2,100 and the one year forward earnings estimate is 134. That makes an earnings yield of 6.3%. Well, the 10 year bond is yielding 2.08% and the 30 year is 2.70%. The model is already breaking down, but let’s just assume that this relationship of the S&P trading with approximately double the risk free rate stays constant. If the US 30 year bond were to go to European levels of 1%, that would mean that the S&P 500 should trade with an earnings yield of 2% to 2.5%. On earnings of 134 that would equate to an index level of 5,300 to 6,700.

No wonder we are getting a massive rush into risk assets. The manipulation of risk free assets to these jaw dropping levels has caused all traditional metrics to be turned on their head.

Some of the smartest investors out there are struggling to understand the implications of these policies.

The biggest buyout fund in the Nordic region says an unprecedented era of monetary stimulus is inflating asset prices across markets to extreme levels, with history offering little help in predicting how it will all end.

"There are financial bubbles being built up and how they'll be solved, I don't know," Thomas von Koch, managing partner at EQT Partners in Stockholm, said in an interview. "The problem is global, not just for Europe. It's the asset bubbles in general that concern me. It's wherever we look."

Charting a path through markets today poses challenges most portfolio managers haven't faced before. Economic theory taught us to expect hyper-inflation when money costs nothing; instead we now face the threat of deflation. "I can virtually toss those textbooks in the fire," said von Koch. From an investor perspective, the development means stocks that track economic cycles are less appealing, he said.

There is a real risk that the financial system becomes completely unhinged. As risk assets are pushed up due to the TINA factor (There Is No Alternative), we enter the Soros reflexivity rise section. Discounting future cash flows at ever declining rates that are approaching zero causes these models to rise exponentially. Yet does it really make sense to triple what you are paying for a dollar of S&P earnings because the 30 year falls to 1%? I guess if you shorted bonds against the S&P it might protect you, but how many investors are doing that?

Some day rates will go back up, and the problem will be that the behaviour around the zero rate discounting will work in reverse.

But in the mean time, the “just get me in” stage is in full force. Risk assets are incessantly bid. I am actually just as scared about a melt up as a melt down. If these portfolio managers stick to the models with these risk free rate levels, it will result in a push higher that might even rival the greatest bubbles in history.

However, I am not going to do anything except watch from the sidelines and wait for the inevitable collapse. Rates of 0.35% for German bunds, or 0.50% for JGBs are not sustainable over the long run. They are the fuel for the current mad dash into risk assets, but my suspicion is that it is like throwing gasoline on a fire – it causes quite a big whoosh, but it quickly burns out.

In the mean time, get ready for some action of biblical proportions… Yes, dogs and cats living together type of action.