Earnings update: March 2, 2013: is the Fed Model Irrelevant at this Point, or is it Telling Us Something Vital ?

Per ThomsonReuters, the “forward 4-quarter” earnings estimate rose this past week to $112.39 from $112.32.

Here are the vital stats in terms of the valuation for the SP 500, based on the ever-evolving earnings data:

P/E ratio: 13.5(x) (same as last week)

Earnings yield: 7.40% (Doug Kass, Jeff Miller and JPMorgan’s Dr. David Kelly are the only 3 to ever talk “earnings yield”)

Y/Y growth in forward estimate: 6.10% (never discussed, very relevant)

Full-year 2013 SP 500 earnings growth is now expected at 9.3%, versus 10.1% on January 1.

With 95% of the SP 500 having reported their 4th quarter results, SP 500 earnings growth for q4 ’12 is 6%, versus the +2.9% expected on Jan 1, ’13. Revenue growth came in better than expected at +3.7%, better than the 3rd quarter’s 1%.

q1 ’13 earnings growth has now slipped to +1.4%, which is lower than expected. It is still just a personal opinion, but I do think Q3 ’12’s earnings growth of close to 0%- 1% for the SP 500 will be the nadir for this cycle. I fully expect q1 ’13’s earnings growth to be low single digits, but still better than q3 ’12. Whether it can be better than q3 ’12’s 0% – 1% remains to be seen. We have 6 weeks remaining until q1 ’13 earnings start getting released.

We still think Financials and Industrials represent safe haven sectors for the remainder of 2013.

The Fed Model

Alan Greenspan warned in 1997 Humphrey-Hawkins testimony that with the 10-year Treasury yield being so far above the “earnings yield” on the SP 500, the Fed Model indicated the stark overvaluation of the US equity market at that time. (It would be another 30 months before the SP 500 actually peaked.)

Here is where the key metrics stood in August, 1997 using some of our old data:

SP 500 price level: using our technical software, the SP 500 was trading around 900 – 950 in August, 1997 (we will use 925);

SP 500 earnings: the actual dollar earnings figure for the SP 500 in 1997 was $43.50;

The 10-year Treasury yield was trading between 6% – 6.50% in August, 1997 (we will use 6.25%);

SP 500 earnings yield in August, 1997: 4.70% ($43.50 divided by 925)

To bring the SP 500 into “fair valuation” with a 6.25% 10-year Treasury, the SP 500 in August, 1997, needed to correct to 696 – 700 or roughly 25%.

Today’s data:

Earnings yield on the SP 500 is 7.40%

10-year Treasury yield is 1.88%

SP 500 earnings estimate: $112.39

SP 500 value: 1,518.20

Even if we assume a 3% 10-year Treasury yield, the SP 500 would need to RISE to 3,746 ($112.39 divided by 3%) to bring the equity markets into fair value with a 3% 10-year Treasury yield.

Assuming a 5% 10-year Treasury yield, the SP 500 would still need to increase 48% from its current level ($112.39 divided by 5%) to bring the SP 500 into parity.

In August, 1997, the Fed Model spread was a negative 155  (470 – 625) basis points. Today it is a positive 552 basis points (740 – 188) , so you might conclude the SP 500 is far more undervalued today, than it was overvalued in August, 1997.

Conclusions / talking points:

1.) The Fed Model is remarkably flawed (here is the Fed Model defined in Wikipedia) but perhaps the Fed Model is flawed as a TIMING tool;

2.) The USA is now Japan, where exceptionally low and even negative interest rates bear no relevance to equity market valuations;

3.) The US stock market, from a longer-term perspective is remarkably undervalued, while the Treasury market is remarkably overvalued;

Although all my degrees are in Finance, I’ve long been a “jailhouse economist” and have enjoyed the writings of many quality economists like Jeff Miller, Brian Wesbury, Ed Hyman, and Ed Yardeni (who named the Fed Model, by the way) and so many others who have helped develop my thought process on the relationship between the stock market and the US economy.

Today, it would be far easier to make a case for #1 and #2 (especially #2 as some think the US economy is in a liquidity trap), and far fewer are making the case for #3, which I think, is the better probability.

The SP 500 peaked in March, 2000 with a p.e. ratio of 25(x) forward earnings. The SP 500 peaked again in October 2007 with a p.e. ratio of 16(x), and the SP 500 is nearing its old highs again in the spring of 2013 with a p.e ratio of 13(x) forward estimates.

Housing is in a full recovery, Europe seems more stable given the action in some of the sovereign 10-year government bonds like Spain, and Italy, China is recovering and it looks like Japan is recovering.


Japan play – we continue to keep Sandisk (SNDK) in client accounts as a Japan recovery / weak yen play. For every 10% decline in the yen, SNDK’s gross margin should expand by roughly 400 bp’s. We would buy more SNDK at $45, with peak earnings for SNDK possibly being $6 in 2013. Depends what multiple is assigned that estimate. SNDK begings to lap tougher comp’s after the 2nd quarter, ’13 release. (Long SNDK). Tiffany (TIF) is another potential Japan play but we missed it. Have to wait for it to come in now.

Facebook (FB) held serve on Thursday and Friday after it looked like it was going to drop all the way to $25. News of a presser next Friday, March 8th to talk about a new news feed, buoyed the stock on Thursday. FB is employing the Amazon strategy – they are investing heavily in operating expenses like RD and SGA, and crushing estimates, as revenue estimates continue to work higher. (Long FB and AMZN).

Basic Materials: year-to-date as of Feb 28, Basic Materials were up 2.5%, not bad giving the drubbing the sector earnings estimates have taken. We are doing some work on the sector and will have more next week. Some cheap stocks in the group. (Long AA, like a canker sore that just wont go away. How I continue to stay in this stock is just completely beyond me.)

Feb jobs report: due out March 8th, expectations are for another 150,000 jobs created by the US economy in February, 13.

Honeywell (HON) has an analyst meeting Wednesday. Industrial / Defense play that we wish would come in to  the low $60’s. (none)

Thanks for stopping by and thanks for reading:

Trinity Asset Management, Inc., by:

Brian Gilmartin, CFA

Portfolio manager

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