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FED Model, Earnings Trends; Some Context for it

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As of October 10 the Forward 12-month (FTM) consensus estimate for Operating Earnings on the SPX is at $59.53. The all-time high was just shy of $63, back in '00. Trailing Operating Earnings through the September quarter (according to Standard & Poors, as of 10/16) are at $51.27. Trailing Reported Earnings are at $37.02. But that gap of $14.25 between Reported and Operating Earnings will close at the end of 4Q03 by at least $7 when 4Q02 falls off the look-back period. The current run rate for Reported Earnings is about $44.

Forward EPS estimates have risen at an 18% annualized rate over the past 3 months, at a 15% rate over the past 6 months, and at an 8% rate over the past year. Trailing Operating EPS have risen 23% in the past year. Reported EPS have also risen 23% in the past year.

In this context it's tough to predict a market crash. But keep an eye peeled for how the market responds when the acceleration in earnings tapers off, which it is bound to do sometime next year.

In essence, Ed Yardeni's "Fed model" suggests that the Forward 12-month (FTM) Operating Earnings Yield on the SPX should be about the same as the dividend yield on the 10-yr Treasury. (The implicit assumption(?) is that Risk in stocks is offset by Growth in earnings.) So we can calculate Fair Value in this model by dividing the FTM consensus estimate by the 10-yr Note's yield. Right now the FTM EPS estimate is $59.53. The 10-yr Note's yield is 4.39%. So, 59.53/0.0439=1356. That's the Fed's Fair Value for the SPX, about 317 points higher than current levels.

The Fed Model

A history of the Fed model shows relative under- and overvaluation of stocks vs. the 10-year Treasury note.

*Ratio of S&P 500 index to its fair value (12-month forward consensus expected operating earnings per share divided by the 10-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after. Source: Prudential Securities, Thomson Financial

Risk Premium

And what accounts for this 317 point disparity? Risk Premium.

What would the Fair Value yield on the 10-yr Treasuries have to be at current S&P500 levels? In other words, what would the denominator on the left side of the equation (10-yr yield) have to be in order for the market's current level to be "fair" in the Fed's model. The simple algebra looks like this.

59.53/X=1039 (Current S&P500)