The Stock Market Moves Closer to Fairly Valued

According to the “Fed Model,” the stock market is still undervalued but a lot less than it was a few weeks ago.
Thanks to yesterday’s big market move and the recent uptick in long-term rates, the stock market is currently 12.5% undervalued according to the Fed Model compared with over 30% just four months ago.
There are many variations on the Fed Model. For our purposes, I use the trailing twelve months of smoothed operating earnings and the 10-year Treasury bond. The current yield on the T-bond is 5.116% so the inverse works out to a P/E ratio of 19.55, and the market’s P/E ratio is 17.09.
Here’s a look at the S&P 500 and the Fed Model.

The market has been undervalued for five straight years.
Preemptive Strike on Critics: No, I’m not saying this is the perfect measure of the market. It’s simply one measure (a good one) and should always be seen in context of other measures of valuation.
Obviously, it can also be saying that the bond market is overpriced. Also, “overpriced” doesn’t have a big impact on what the market actually does. In fact, only when the market is 41% or more overpriced does history suggest that it’s worth selling.

Posted by Eddy Elfenbein on July 13th, 2007 at 6:19 am

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