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Equity Valuation in a Volatile Market

by Colin Gustafson
Wed, 6 Feb 2008 at 10:34 AM

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According to the so-called Fed model of equity valuation, investors measure whether equities are undervalued or overvalued by comparing the yield on the S&P 500 Index to the yield on a 10-year Treasury bill.

Equity researcher Barry Ritholtz (The Big Picture) notes one potential problem with this model: The equation used to compare the yields includes the earnings estimates for S&P 500 companies, which can be wrong. The result is that the Fed model often promotes a bullish stance on equities when the American economy is inching toward a cyclical recession because the model will indicate that stocks are undervalued when in fact earnings estimates are too high.

"It is not that the Fed model is so terribly wrong — it has been both right and wrong over the years," Mr. Ritholtz writes. "Rather, it is the way too many people conceptualize it."

At a time when the markets are experiencing widespread sell-offs amid fears of a recession, Mr. Ritholtz suggests that investors may want to err on the side of caution and chock the Fed model up to the fact that earnings estimates are "wildly exuberant."

"Perhaps, equities are seriously undervalued." he writes. "But to treat the Fed model as if it merely looks at valuation ... is to ignore a key variable — future earnings consensus — that tends to be wrong at the worst possible moment."

ECONOMETRICS-BASED STUDY: TIME HEALS OLD WOUNDS

How do life-altering events such as marriage, divorce, and unemployment affect our long-term satisfaction?

As an economics professor at the University of Oregon, Mark Thoma, points out on his blog (Economist's View) this week, a group of European and American researchers are using the language of time-series econometrics to find the answer.

Their conclusions, drawn from studying two decades of German Socio-Economic Panel data on trends in marriage, divorce, employment, and childbirth, boil down to remarkably simple maxims: Happiness is fleeting, and time heals all wounds.

Getting a raise or being hired, for instance, "may produce a great deal of pleasure initially," the authors write, "but somehow become less important as time goes on, retreating into the background humdrum."

The same can be said of negative life changes like being fired: People eventually adapt and move on, but with one exception. According to the study, many of those who remained unemployed also tended to stay unhappy.

For more insight from the country's leading economics blogs, go to nysun.com/blogs.php.

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