From the Editor - March 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Modifying the Fed Model

In our last newsletter we spoke of the importance of following an investment model on a consistent basis rather than jumping from model to model, or letting emotion guide one’s decisions. Now, only one month later we must announce that we are deviating from our own model, and thus our own advice. We hope that you will not accuse The Prudent Investor of being imprudent after hearing our reasons. The actual change is relatively minor in the scheme of things.

We use the Fed Model to help us gauge the relative valuation of equities to fixed income. The model has signaled that equities are undervalued relative to bonds ever since November 2002 (with one brief pop into overvalued territory in January 2004). Not coincidently, this entire time period has proven to be quite healthy for the stock market, and especially attractive for our Model returns. Over the past eight months, the Fed Model has averaged an unusually steep 22% undervaluation relative to bonds. You may recall that virtually all of 2004’s gains (10.9%) on the S&P 500 occurred during this same time period. The Fed Model correctly signaled quite positive conditions for equities during this time frame.

If the model has been so generally reliable over the past few years, why tweak it now? A fair question. In our February newsletter we discussed the unusual move by the yield curve, and the potential implications of the “flattening” curve. The unmodified Fed Model suggests market undervaluation of 23%, based on a current 10-year Treasury yield of 4.38%. Given the odds in favor of a higher bond yield later this year as the Federal Reserve continues to raise short-term rates, we think there could be downward pressure on equities. (Even so, our projection for the entire year is that the overall market will end in positive territory.) Because we hold this view, we feel it reasonable to make a slight adjustment to the Fed Model by building into the model an assumed 10-year Treasury note yield of just over 5%, rather than the 4.38% yield that exists today. This brings the Fed Model down to “only” 9.8% undervaluation compared to fixed income, still an aggressive signal, but less so than 23% undervaluation. Our modification of the Fed Model has the result of forcing us to be slightly less aggressive with purchasing equities than we might otherwise be.

Let’s consider the opposite alternative, where short-term rates continue to rise and long-term rates continue to fall. Eventually, we can reach a situation where the yield curve is inverted. As we discussed last time, historically an inverted yield curve almost always signals a recession. In our last newsletter we stated, “In virtually every instance over the past 100 years where the yield curve went negative, an economic recession ensued within the next six months.” In the less likely event of a recession within the next 12-18 months, we certainly would want to be lighter on equities, lighter in fact than even our current Asset Allocation Model suggests in Table 3, using our modified Fed Model.

Leveraging at the Top?

One very recent piece of information that has encouraged us to adjust the Fed Model signal was reported in the February 28, 2005 edition of Barron’s. Barron’s reported that in the past month there has been unusually heavy buying on margin by individual investors, suggesting these margin traders are extremely bullish on the stock market. According to longtime market observer Walter Deemer, speaking of the level of margin buying, “I can’t remember a stretch that has been this heavy for this long.” From a contrarian standpoint, this is a very bearish signal. The “average investor” is typically most bullish at the very top of a market, just before a correction. (This editor recalls a discussion with a Boston-area pizza maker who had begun day trading during the daytime in between making pizzas for customers, about two months before the bear market began in 2000. His euphoria, along with so many others, almost perfectly marked the top.)

Given the current market environment, we are not excited about leveraging our investments via trading on margin, and the fact that many novice investors are doing so makes us all the more wary. It will be interesting to see if these excited investors do, in fact, mark at least a short-term high for the market for this year.