This Little-Known Indicator Says Stocks Should Double

With the markets breaking all-time highs last week, it begs the question of just how high they can go.

At 1,569 points the bears would say at this point the S&P 500 is completely overdone. With a sluggish economy and a growing federal deficit, you might be prone to believe them.

But there is a little-known indicator that became very fashionable between 1982-2007 that says something else entirely. Noted for its accuracy over that period, it actually suggests that stocks should double.

It's called the "Fed Model."

It's based on a principle that the earnings yield on the Standard and Poor's 500 index should be the same as the yield on the 10-year Treasury bond.

Using today's trailing four quarters of S&P 500 earnings of $85.39 and 10-year Treasuries yielding 2.03%, the model gives a value for the index of 4,206 -- well over double the current figure.

How Accurate is the Fed Model Today?

Of course, stock market valuation models are an attempt by market fundamentalists to figure out where the market should trade, and whether they should be buying or selling at a given moment.

When I was in business school, we were taught that the value of a stock was the discounted present value of its stream of dividends.

By that standard, the Fed model is over-generous. It assumes that all earnings have full value to investors, whether they are paid out as dividends or not.

It also assumes that you discount at the 10-year Treasury bond rate, without taking account of the greater risk stocks pose in relation to bonds. On the other hand, it doesn't take into account that stocks offer greater protection against inflation compared to bonds.

Most of the time, the "Fed model" gives a valuation that is rather above the market's normal trading level - this is why it became so attractive to Wall Street analysts, most of whom are fundamentally in the business of selling stocks.

On a historical basis, The Fed Model tracked the market's actual performance pretty well for a period of 25 years, enough to make it a cherished icon on Wall Street.

But that could be coincidental since between 1982-2007, interest rates began at a very high rate and then declined steadily, while stocks rose.

Here's what we do know: After 2007, the Fed Model went spectacularly wrong. Interest rates were forced down by Ben Bernanke, so the Fed Model valuation of the market rose.

However, the exact opposite happened and the market fell out of bed. Admittedly, right at the bottom, in the fourth quarter of 2008, the earnings on the S&P 500 index were negative mostly because of the big bank write-offs. But the earnings recovery came quickly and interest rates stayed very low, even falling further.

So there's a Ben Bernanke-inspired mismatch that the Fed Model gives a stock market valuation more than twice the current level.

The Fed Model As a Crystal Ball

As suggested above, I believe the Fed Model is only right by accident. However, lots of people follow it, and they have a hell of a lot more money than I do.

That means there's currently a strong force pushing the market up towards the Fed Model valuation, which may well get stronger now that the market has hit new highs and is climbing into new territory.

That means either stocks have to rise a lot, or interest rates do.

In what looks to me like the first gentle downward slope in a big bear market for bonds, interest rates are already gently rising. Of course, Ben Bernanke is buying $85 billion of long-term Treasury and mortgage bonds each month, pushing the market further and further from where it naturally wants to go.

Even though the U.S. economy is looking a bit stronger and inflation is showing signs of ticking up, I still believe Bernanke will strongly resist any call to raise short-term rates, or even to stop buying bonds.

That will increase the upward push on the stock market. Even if bond yields go on rising gently so that the 10-year Treasury yields 3%, the Fed model would still give a valuation of 2,846 for the S&P 500 index.

That's why I don't think the S&P 500 index will make it to 4,206. But I do think it might get as far as 2,494, which matches the peak of March 24, 2000 (1,527) adjusted by the rise in nominal GDP (including inflation) since then.

If that happened, stocks would rise almost 60% from current levels and would match the valuation excesses at the top of the dot-com boom.

But don't worry bears, the market won't stay there. At some point, probably because inflation ticks up to a level we really notice, Bernanke will have to reverse policy or, more likely, will be dragged kicking and screaming away from the controls.

Then the bond market, free from Bernanke's artificial torrent of purchases, will crash, and yields will rise, probably to around 5%, their level in 2007 (they may need to go further before inflation is conquered, however). Without the bond market pushing it upwards, the stock market will crash.

How far will it crash? Well, on February 23, 1995, the day Fed chairman Alan Greenspan changed U.S. monetary policy and started printing the stuff, the S&P 500 index stood at 487.

Inflate that by nominal GDP since the first quarter of 1995 and you get to 1056. Take the Fed Model on cyclically-adjusted earnings and the 1962-2012 average of interest rates (6.6%) and you get to 981. A similar calculation on dividend yields, where the long-term average yield is 3.3%, gives a level of 935.

In other words, all three methods agree that the S&P 500 index will at some point fall to around 1,000.

So here's the bottom line for investors: You better make some serious $$$ on the way up in 2013, because 2014 doesn't look too good-even if you use the Fed Model.

Related Story Links: