MacroView: The Fed’s View Of Valuations May Be Misguided

On Wednesday, the Federal Reserve concluded their January “FOMC” meeting and released their statement. Overall, there was not much to get excited about, as it was virtually the same statement they released at the last meeting.

However, Jerome Powell made a comment which caught our attention:

“We do see asset valuations as being somewhat elevated” 

It is an interesting comment because he compares it to equity yields.

“One way to think about equity prices is what’s the premium you’re getting paid to own equities rather than risk-free debt.”

As we have discussed previously, looking at equity yield, which is the inverse of the price-earnings ratio, versus owning bonds is a flawed and ultimately dangerous premise. To wit:

“Earnings yield has been the cornerstone of the ‘Fed Model’ since the early ’80s. The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you should invest in stocks and vice-versa.”

The problem here is two-fold.

1. You receive the income from owning a Treasury bond, whereas there is no tangible return from an earnings yield. For example, if we purchase a Treasury bond with a 5% yield and stock with an 8% earnings yield, if the price of both assets remains stable for one year, the net return on the bond is 5% while the return on the stock is 0%. Which one had the better return? Furthermore, this has been especially true over the last two decades where owning bonds has outperformed owning stocks. (Data is total real return via Aswath Damodaran, NYU)

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2. Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. However, while stocks may have an “earnings yield,” which is never received, stocks have price risk, no maturity, and no repayment of principal feature. The risk of owning a stock is exponentially more significant than owning a “risk-free” bond.

This flawed concept of risk, as promoted by the Federal Reserve, also undermines their view of current valuations.

I have spilled an enormous amount of “digital ink” discussing the importance of valuations on future returns for investors, and most recently, why high starting valuations are critically important to individuals at, or near, retirement.

“Over any 30-year period, beginning valuation levels have a tremendous impact on future returns. As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.”

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Not surprisingly, valuations are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are not strong predictors of 12-month returns. This was a point made by Janet Yellen in 2017:

“The fact that [stock market] valuations are high doesn’t mean that they’re necessarily overvalued. For starters, high valuations don’t portend lackluster returns in the near term. History shows that valuations provide no reliable signal as to what will happen in the next 12 months.”

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Disclaimer: Real Investment Advice is powered by RIA Advisors, an investment advisory firm located in Houston, Texas with more than $800 million under management. As a team of certified and ...

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