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FED Model, Earnings Trends; Some Context for it - Page 2

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Solving for X...

1039X=59.53 X=59.53/1039 X=.0573

Or, the 10-yr's yield would have to be 5.73% to make SPX 1039 Fair Value. With the 10-yr yield now at 4.39% the difference between the Fair Value yield and the Actual yield is +1.34%. That's the risk premium.

But the average Risk Premium on this reckoning since '94 has been 0.11%, which makes the current perceived risk in the market (at 1.34%) high by comparison.

Earnings Estimates in the data base only go back to '94. But actual earnings data go back much farther (to 1927 in fact). So what follows is a look at the last 43 years, going back to 1960, using actual year-forward earnings as a proxy for the Consensus Estimate in the Fed's model. Of course the drawback is that our calculation of Fair Value using actuals has to stop a year ago.

Why stop the look back at 1960? Before that we start dealing with the aftermaths of the Great Depression, WWII, the Korean War, and the immense structural economic transitions that were wrought in the first half of the 20th Century. If you want to argue that the markets should function today as they did prior to 1960, that's a whole new topic.

Since 1960 the average SPX FTM operating earnings yield has been identical to the average yield on the 10-yr note! In other words, the average Risk Premium from 1960 to the present (using year-forward actual operating earnings in solving for X) is zero. The Fed's model looks pretty good, over all.

This look-back period includes the sexy '60s, the inflation-ridden '70s, the deficit-burdened '80s, the Goldilocks '90s, and the anti-bubble of the past 3 years. It's an interesting cross-section of economic history. And it suggests that the Fed model's Risk Premium, with a standard deviation from the mean of 2.2% over this period (assuming a normal or near normal distribution) would fall between -2.2% and +2.2% about two-thirds of the time.

Of further interest is that since 1980 the average risk premium is -1.46% with one standard deviation being 1.3%. So, over the past 23 years risk premium has been between -.16% and -2.76% about two-thirds of the time.

And where are we now?

Well, obviously we don't have actual earnings for October '04 yet but we do have the analysts' consensus estimate. Using FTM Estimates, Risk Premium is now at about 1.34%, which is high but not excessive relative to the past 43 years (inside 1 standard deviation). Relative to the past 23 years, however, the Risk Premium is more than 2 Standard Deviations above the mean.

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