Don't Buy Stocks for the Wrong Reason

Following useless indicators can cost you money.

Over the past few weeks, I've repeatedly heard pundits claim that stocks are now undervalued, since the Dow's dividend yield has surpassed that of the 10-year Treasury. When I asked financial economist Andrew Smithers, the author of Wall Street Revalued, for his opinion on this, he didn't mince words:

It is clearly nonsense to claim to value equities on the basis of bond yields. It assumes that equities are not correctly priced, but that bonds are. Why not point to the yield relationship and say that we have a bond bubble on our hands?

This is a version of the so-called Fed Model which argued that you could price equities by reference to the relationship between the earnings' yield on equities and bond yields [Note: The earnings yield is the inverse of the P/E ratio]. The evidence was that the relationship had been stable from 1981 to 1997. This was one of the greatest successes ever achieved by data mining, as the inverse relationship held, in a slightly stronger form, from 1950 to 1968.

Recently, my esteemed colleague Morgan Housel used the Fed model to argue that stocks are the best buy right now. He examined the historical data, making an imaginative adjustment to the dividend yield to account for the enormous change in corporate and investor attitudes toward dividends that occurred post-WWII. Indeed, as Morgan noted:

Today, some of the most profitable and fastest-growing companies -- including Apple (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  ) , and Cisco (Nasdaq: CSCO  ) -- pay no dividends at all. The slow-growers -- like Altria (NYSE: MO  ) , Verizon (NYSE: VZ  ) and Consolidated Edison (NYSE: ED  ) -- are where you find yield. That was unheard of 60 years ago.

The adjustment was a good instinct, and it led Morgan to this discovery:

… [Once you adjust for the change in payout ratio] there would have been only two [prolonged periods in which stocks out-yielded bonds] in modern history: from 1940-1944, and 1947-1955.

And what's neat about these two periods? They were both phenomenal times to buy stocks. In the 10 years after 1944, stocks surged 161%. In the 10 years following 1955, investors were rewarded with a 145% return...

A leap too far
All that is true, but it doesn't support Morgan's final, fatal leap of logic: "Today, with the average large-cap stock out-yielding Treasuries, there's little reason to think patient investors won't be rewarded like champions 10 years from now."

Why not? Let's get back to those impressive 10-year numbers, and find out what's behind them. In the table below, I've annualized the price returns, and broken them down into two components: earnings growth and the change in the price-to-earnings multiple (P/E). The first measures corporate performance, while the second captures what the market will pay for that performance.

Metric

1944 – 1954

1955 – 1965

Historical Average (1926-2000)

Earnings Growth

11.5%

4.3%

4.9%

Change in P/E Multiple

(1.3%)

4.5%

1.2%

Return (Ann.)

10.1%

9%

6.2%

Source: Robert Shiller and Stock Market Returns in the Long Run: Participating in the Real Economy (2003), Ibbotson and Chen.

It's all in the earnings growth (and more!)
In the first period, earnings growth contributed more than 100% of the return, because the P/E multiple contracted, subtracting from the return. Note that the annualized earnings growth rate for the 10-year period, 11.5%, is more than twice the average historical growth rate (4.9). In other words, stock investors earned high returns during this period not because stocks started out cheap, but because earnings growth was unusually strong. We certainly shouldn't count on that occurring over the next 10 years, especially with consumers continuing to deleverage.

In the second period, the contributions of the two factors are almost equal, but while earnings growth is close to its historical average, the increase in the P/E multiple contributes much more heavily to stock returns than the long-term average (4.5% vs. 1.2%). This does suggest that stocks were undervalued at the start of the period.

Don't be fooled by this indicator!
The conflicting indications regarding stock valuations in the two examples show that even though stocks are out- yielding bonds, that still won't tell us whether stocks are cheap or not. If you do believe stocks are cheap now, you'd best have another reason for it.

Incidentally, James Glassman and Kevin Hassett relied on a variation of the Fed Model in coming up with Dow 36,000, which was published in October 1999. We all know how well that madcap prediction worked out.

From 1926 to 2000, dividends contributed 40% of stocks' average annual return. Over the next decade, their contribution could be even higher. Matt Koppenheffer knows where to find the best dividends.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks in this article. Google is a Motley Fool Inside Value selection. Google is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor recommendation. The Fool has written a bull call spread on Cisco Systems. The Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 27, 2010, at 3:50 PM, TMFHousel wrote:

    Here's billionaire hedge fund manager David Tepper on this issue last week:

    "Look where we are right now. Next year, if you believe the estimates, we're trading at just under 12 times earnings on the S&P. You got a 2.5% 10-year Treasury yield. So where should multiples be if you're at a 2.5%-3% 10 year? Not 11 or 12. Should you be at 14? Can you get to 14 and still be really conservative? Abso-freakin-lutely. "

    I don't think it's clearly nonsense to value equities at least in part on the basis of bond yields. The assumption that interest rates have no impact on stock valuations is, I think, the nonsense.

  • Report this Comment On September 27, 2010, at 4:18 PM, TMFAleph1 wrote:

    I caught Tepper's performance on CNBC and I can't say I was that impressed, but I agree that this model is widely used on Wall Street -- to the point where it has become deeply ingrained in investors'/ traders' basic assumptions regarding stock valuation. I have displayed the same thinking myself in previous articles.

  • Report this Comment On September 27, 2010, at 4:23 PM, TMFKopp wrote:

    @Alex

    First, a question for you... In a few articles now you've talked about debunking the Fed model as a reason why the stock/bond yield situation isn't helpful. But doesn't pretty standard valuation fare bring the bond market into the picture through the risk free rate? Or am I missing something?

    Also, a few comments... You seem to imply that stocks are only cheap when the earnings multiple is low. I guess I would argue that stocks are cheap when they're worth more than the price at hand. Undervalued stocks could be due to low earnings multiples, or they could be do to moderate earnings multiples and higher-than-average growth. If we look at it that way, then stocks were cheap in both periods that you examine in your chart.

    "Incidentally, James Glassman and Kevin Hassett relied on a variation of the Fed Model in coming up with Dow 36,000, which was published in October 1999. We all know how well that madcap prediction worked out."

    I also think that this is more than a bit unfair. Reading Morgan's article I hardly got the hint that he's pushing fantastic numbers.

    Also, you also seem to be pushing him into this Fed Model box. While comparing dividend yields to Treasury yields could be considered some perversion of the Fed Model, it's hardly the same thing. I count myself among those that think the dividend yield / Treasury yield is a good signpost that stocks are worth investing in right now, but I'd hardly endorse the P/E near 40 that the Fed Model would indicate as a fair value.

    Matt

  • Report this Comment On September 27, 2010, at 4:44 PM, TMFAleph1 wrote:

    Hi Matt,

    Thanks for your comments/ questions.

    "But doesn't pretty standard valuation fare bring the bond market into the picture through the risk free rate? Or am I missing something?"

    This is an objection that I have myself and I have not yet been able to resolve the apparent contradiction to my satisfaction.

    "I also think that this is more than a bit unfair. Reading Morgan's article I hardly got the hint that he's pushing fantastic numbers."

    In my last paragraph, I'm not comparing Glassman and Hassett's result and Morgan's conclusions. The only link is that they are both based on a flawed model. Dow 36,000 is simply the extreme illustration of how far astray this model can lead you.

    AD

  • Report this Comment On September 27, 2010, at 5:00 PM, TMFAleph1 wrote:

    Matt,

    Reviewing Asness' paper, I found the explanation of our 'paradox', or the refutation of this defense of the Fed model. See pages 12-15 in:

    Fight the Fed Model, Journal of Portfolio Management, Fall 2003

    http://www.som.yale.edu/Faculty/jkt7/otherpapers/Asness.pdf

    Cheers,

    AD

  • Report this Comment On September 27, 2010, at 5:46 PM, TMFHousel wrote:

    "This is an objection that I have myself and I have not yet been able to resolve the apparent contradiction to my satisfaction."

    That's the problem I have with your argument. It makes so little sense that you don't seem to be able to defend it other than quoting Smithers. To assume what you're saying is right is to say there's no such thing as a discount rate or an opportunity cost. I can't get on board with that.

    Also, I don't think it's fair to keep saying I use the Fed model. Honestly, I had never heard of it before you began accusing me of touting it.

  • Report this Comment On September 27, 2010, at 6:18 PM, TMFAleph1 wrote:

    Morgan--

    It's not that the argument against the Fed model makes so little sense, it's that, as I mentioned earlier, the Fed model is so deeply ingrained in our assumptions about valuation that it is difficult for us to imagine that the reality is otherwise. I put myself in that 'us', although I am healing myself.

    The Asness paper I linked to earlier contains a thorough refutation of the Fed model. Go through it and you'll see that you don't need to assume that there's no such thing as a discount rate or an opportunity cost to refute it.

    Finally, I didn't accuse you of touting the Fed model, I just picked up on the fact that you used it as the basis for one of your articles. This is no crime; as I wrote above, I have used similar reasoning in past articles.

    AD

  • Report this Comment On September 27, 2010, at 7:07 PM, dollarpuppy wrote:

    Thanks for the alternate view to Morgan's article (my intuition alarms were going off as I read it). Not to be a Prechter-parrot, but this sounds like a good example of mid-century real economic growth vs. the past 15 years being more about inflated valuations and an economic shell games.

  • Report this Comment On September 27, 2010, at 7:45 PM, TMFDiogenes wrote:

    Interesting debate.

    Haven't thought this through enough to weigh in yet on y'alls debate, so instead I'll throw a further complication into the mix:

    Why are we using P/Es as the proxy for valuation here -- if growth is high, then a high P/E is justified, if not, not. Furthermore, when we experience appreciation based on expanding multiples, appreciation could mean stocks were undervalued and have become fairly valued, or, alternatively, that stocks became increasingly overvalued over the period, driving returns.

    In other words, one way you can tell -- in hindsight -- whether stocks were over- or under-valued is by looking at stock returns. If they did really well and didn't collapse for a long period, there's a good chance they were probably undervalued. Yes, it's possible stocks were irrationally priced at the end of the period, but you have that problem when you look at P/Es as well.

    Or if you want to be pedantic about it (i.e. you want to get the right answer) you can try to construct a discounted model based on what future earnings were. (Of course, your discount rate is going to depend on .... bond yields bumbumbum...)

    Ilan

  • Report this Comment On September 27, 2010, at 7:49 PM, TMFAleph1 wrote:

    This fallacy is so widespread and pernicious that even the best investing minds fall prey to it. Warren Buffett, for example; see the first page of the following document:

    Mr. Buffett on the Stock Market, Fortune, 11/22/1999, http://www.tilsonfunds.com/MrBuffettStockMarket.pdf

    AD

  • Report this Comment On September 27, 2010, at 8:53 PM, PositiveMojo wrote:

    Your title is a little odd. The answer to your title is the reason people buy stock is to make money.

    It's a HUGE MISTAKE to buy the stock of any company based on macro market information. It's equivalent to saying that if you put your head in the fire and your feet on a block of ice, on averge you'll feel comfortable.

    My first rule of investing is to only buy well managed companies and made a 96.4% return in 2009 following that rule (18.97% in the past two weeks). I first look at financial mgmt - earnings per share over the past 3 years, debt to net earnings, gross profit margin/sales. These happen to be the same criteria used by Warren Buffett.

    If a company makes it past that criteria then I use a set measurements established by Peter Drucker to determine the strength of the management team. It is only after they pass all tests do they even make it on my list. Then I use 5 technical indicators to measure consumer demand for the stock.

    It works for me and I have fun doing it - but it has taken me years and a lot of discipline to get to this point. I think watching macro models is a waste of time an really dangerous and should NEVER be the reason you buy any stock.

  • Report this Comment On September 27, 2010, at 8:58 PM, TMFAleph1 wrote:

    Graybear1951,

    Thanks for your comment. Some people like to focus on stockpicking, others prefer to think in terms of asset classes. For the latter group, broad market indicators can be very useful.

    Alex D

  • Report this Comment On September 27, 2010, at 9:02 PM, TMFAleph1 wrote:

    Graybear1951,

    I congratulate you on your 96.4% in 2009, but I'm not sure why you mention your return over the past two weeks -- the timeframe is much too short to say anything meaningful regarding that number.

    Alex D

  • Report this Comment On September 27, 2010, at 11:27 PM, rd80 wrote:

    Alex,

    Of course stock valuations and bond valuations are linked and compared relative to each other.

    Every time an investor puts money to work in the markets, he or she explicitly or implicitly ranks the valuation of bonds, stocks, commodities, cash, etc. by what's chosen.

    You missed one key point in your critique of using bond pricing as part of a stock valuation model. If stocks aren't really undervalued and bonds are overvalued, what is undervalued?

  • Report this Comment On September 28, 2010, at 1:08 AM, TMFAleph1 wrote:

    @rd80

    "Of course stock valuations and bond valuations are linked and compared relative to each other."

    I agree with that statement, but it is descriptive, not normative, i.e. investors do appear to price stocks with regard to the level of interest rates, but that is not what they should do.

    "You missed one key point in your critique of using bond pricing as part of a stock valuation model. If stocks aren't really undervalued and bonds are overvalued, what is undervalued?"

    I didn't say anywhere that bonds are overvalued, but even if I had, why must one of the two asset classes be undervalued? I am reasoning on an absolute basis here.

    On these points, I HIGHLY recommend the Asness paper that I link to above.

    Best,

    Alex D

  • Report this Comment On October 11, 2010, at 6:11 PM, killerpants wrote:

    With regards to what is undervalued, neither the stock nor bond market appears undervalued. For long-term only investors choosing only amongst asset classes, good luck to you! I don't see much opportunity in the stock or bond market (at least for going long). I could be wrong though. Regardless, maybe some alternative (and probably less liquid) asset class has some opportunity for you.

    Additionally, I do think it can be useful to look at the relative valuation of stock and bond markets, but to value each market individually is also important. Stocks may be cheaper than bonds, but bonds are not cheap (or even fairly valued IMHO). Their yields essentially have nowhere to go but up in the long run, and the Fed cannot keep them low indefinitely.

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