Tuesday, May 21st, 2013

Does the FOMC know about the Fed model?

According to the Federal Reserve Act, the goals of the Federal Open Market Committee are “maximum employment, stable prices, and moderate long-term interest rates.” There is no mention of recapitalizing of the US banking system, or preventing a melt-down in the housing market, but the Fed is clearly aware of the impact of monetary policy on all financial markets, bonds, mortgages and, of course, equities.

The following quote comes from The Federal Reserve System: Purposes and Functions, Chapter 2: “Investors try to keep their investment returns on stocks in line with the return on bonds, after allowing for the greater riskiness of stocks. For example, if long-term interest rates decline, then, all else being equal, returns on stocks will exceed returns on bonds and encourage investors to purchase stocks and bid up stock prices to the point at which expected risk-adjusted returns on stocks are once again aligned with returns on bonds.” This equation, focusing on expected returns, forms the basis of the Fed model, and it is still the nearest thing we have to an official explanation of the impact of monetary policy on equity markets.

Running the numbers, we get a forecast earnings yield of 6.9% (based on 115 consensus eps for the next 12 months), and an expected excess return of 5.3%, based on a nominal bond yield of 1.6% (7-10 index). This figure is compared with the excess volatility of equities versus bonds, which we track religiously as part of our PRATER process. Over the last 17 years, average excess volatility is 9.5%; the low is -1.0% and the boundary of the first quartile is 5.3%. In other words, the expected returns currently available from equities would have fully compensated investors for the extra risk of equities for only 25% of the sample period.

Another way of looking at the data is in terms of a price for risk, measuring excess returns as a percentage of excess volatility. The numbers are 5.3% for excess returns compared with 9.2% for excess volatility. This means that investors can only expect to be compensated for 60% of the extra risk they have been running in equities. The Fed model is now discredited as a predictive tool, partly because of the FOMC’s own actions over the last decade, but we assume that someone has told them what their own model implies. As every week of this rally goes by, it gets harder to argue that “expected risk-adjusted returns on stocks are aligned with returns on bonds.”

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