The Not-So-Big Picture on Financial Models

Rarely do I disagree with fellow investor and financial blogger Barry Ritholtz, but the time has finally come. Last week Barry wrote a column for Bloomberg View called “Why ‘Peak-Earnings Models’ Are Nonsense .” Though I don’t agree with everything I read, and I hardly ever expend the energy to write a long response, this time I saw an opportunity to discuss several important topics: the Fed model (where Barry and I actually agree) and profit margins and the P/E model (where we disagree).

In his article Barry argues that the Fed model is flawed because it compares two variables — valuations implied by interest rates (the inverse of the ten-year Treasury yield) and actual valuations, market price-earnings — to tell you whether stocks are cheap or expensive. Barry writes, “The problem with the formula is that it contains not one but two variables. … Hence, the Fed model tells you one of two things: Either equities are over/undervalued, or consensus earning estimates are either too high or too low.”

I agree that the Fed model could be telling you that stock valuations are too low or too high in relation to interest rates, but this assumes that interest rates are at the right level and will be at this level in the future. Current interest rates could be too high or too low as well, especially in an environment in which governments globally set the levels of short- and long-term interest rates, rather than letting the market do it. Also, the Fed model confuses an intuitive relationship (that is, higher interest rates lead to lower P/Es and vice versa) with a direct relationship.

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