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Enrich Your Future 09: The Fed Model and the Money Illusion

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Quick take

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 09: The Fed Model and the Money Illusion.

LEARNING: Just because there is a correlation doesn’t mean that there’s causation.

 

“Just because there is a correlation doesn’t mean that there’s causation. The mere existence of a correlation doesn’t necessarily give it predictive value.”

Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 09: The Fed Model and the Money Illusion.

Chapter 09: The Fed Model and the Money Illusion

In this chapter, Larry illustrates why the Fed Model should not be used to determine whether the market is at fair value and that the E/P ratio is a much better predictor of future real returns.

The FED model

The stock and bond markets are filled with wrongheaded data mining. David Leinweber of First Quadrant famously illustrated this point with what he called “stupid data miner tricks.”

Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh. His example perfectly illustrates that a correlation’s mere existence doesn’t necessarily give it predictive value. Some logical reason for the correlation is required for it to have credibility. Without a logical reason, the correlation is just a mere illusion.

According to Larry, the “money illusion” has the potential to create investment mistakes. It relates to one of the most popular indicators used by investors to determine whether the market is under or overvalued—what is known as “the Fed Model.”

The Federal Reserve was using the Fed model to determine if the market was fairly valued and how attractive stocks were priced relative to bonds. Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the earnings-price, or E/P, ratio (the inverse of the popular price-to-earnings, or P/E, ratio).

Larry points out two major problems with the Fed Model. The first relates to how the model is used by many investors. Edward Yardeni, at the time a market strategist for Morgan, Grenfell & Co. speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments.

The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds.

Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, estimated inflation must be added. This is a critical point that seems to be lost on many investors. This leaves a trail of disappointed investors who believe low interest rates justify a high valuation for stocks without the high valuation impacting expected returns. The reality is that when P/Es are high, expected returns are low, and vice versa, regardless of the level of interest rates.

The second problem with the Fed Model, leading to a false conclusion, is that it fails to consider that inflation impacts corporate earnings differently than it does the return on fixed-income instruments.

Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy. Thus, in the long term, the real growth rate of earnings is not impacted by inflation.

On the other hand, the yield to maturity on a 10-year bond is a nominal return—to get the real return, you must subtract inflation. The error of comparing a number that isn’t impacted by inflation to one that is, leads to the money illusion.

Understand how the money illusion is created

Understanding how the money illusion is created will prevent you from believing an environment of low interest rates allows for either high valuations or high future stock returns. Instead, if the current level of prices is high (a high P/E ratio), that should lead you to conclude that future returns to equities are likely to be lower than has historically been the case and vice versa. This doesn’t mean investors should avoid equities because they are highly valued or increase their allocations because they have low valuations.

Further reading

  1. Kiplinger’s Personal Finance, February 1997.
  2. Humphrey-Hawkins Report, Section 2: Economic and Financial Developments in 1997 Alan Greenspan, July 22, 1997.
  3. William Bernstein, “The Efficient Frontier,” (Summer 2002).
  4. Clifford S. Asness, “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns,” (December 2002).

Did you miss out on the previous chapters? Check them out:

Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

Posted in Enrich Your Future, Podcast