Analysing the Fed Model

What happened to the so-called Fed model? Although it was never actually endorsed by the Federal Reserve, the idea of comparing the 10-year Treasury yield and the earnings yield (earnings divided by price) on the S&P 500 (SNPINDEX: ^GSPC  ) has become a standard valuation tool for many investors. Moreover, for investors in SPDR S&P 500 (NYSEMKT: SPY  ) or the iShares Core S&P 500 (NYSEMKT: IVV  ) , a view on the value and future direction of the indexes is a critical part of investing. So how useful is the model, and what can investors learn from it?

Introducing the Fed model
As usual with valuation methodologies, there is no end of disagreement over which input factors to use. For reference, the earnings used in the following charts is as-reported, rather than adjusted. All of the raw data used comes from Noble prize winning economist Robert Shiller's website at Yale. 

The basic theoretical idea behind the model is simple. An investor faced with buying bonds or equities might choose between a 10-year U.S. Treasury yielding, say 5%, or buying an equity with an earnings yield (earnings/price) of 5%. Roughly speaking, when the Treasury yield is below that of equities then it makes sense to buy equities, and vice versa.

The following chart compares the long-term performance of these two variables. As a rough guide, when the earnings yield (in red) is above the 10-year Treasury yield (in blue) then equity markets are seen to be cheap and vice versa.

Source: Robert Shiller Home Page.

Yes, you are reading the chart correctly! The model is implying that the S&P 500 is a screaming buy right now. So does that mean that equity investors should just pile into index ETFs and enjoy the ride upward?

The answer depends on how much you trust the model.

A false friend
The model became popular in the '80s and '90s because it appeared to provide a very useful way to judge the future direction of the S&P 500. In fact, plotting the 10-year yield (x-axis) against the S&P 500 P/E ratio (y-axis) and performing a regression analysis on the data produces a remarkable result.

The best-fit trendline in the chart generates an equation with a coefficient of determination, or R^2, of 0.83; a result which indicates a very strong relationship. In plain English, the equation (rounded up) of y=0.98x-1.5 means that for a 10-year yield of, say 5%, the S&P 500 earnings yield should be equal to 0.98*5-0.015=4.9%. Since the earnings yield is the inverse of the P/E ratio, this implies a P/E ratio of around 20 times.

Source: Robert Shiller, author's analysis.

It's not hard to see why this metric became popular, because from 1980-2000 it appears to offer a failsafe way of investing in bonds or equities!

However, Foolish readers will note from the first chart that the relationship seems to break down after the year 2000. In fact, from 2003-2013 there is only one period where equities where not "cheap." That's 2009 when earnings (and therefore the earnings yield) collapsed during the recession.

Three explanations
There are many ways to interpret the relative cheapness of equities to bonds right now, or rather to interpret what the market is interpreting on the issue.

One approach suggests that bond yields are being artificially held down by massive injections of liquidity by the Federal Reserve. Therefore, equity investors may be saying that they don't really believe that equities are relatively cheap, because either interest rates will inevitably go up in a few years or earnings will fall in the future. Alternatively, both events could happen concurrently. For example, a collapse of confidence in lending to the U.S. could lead to Treasury yields rising, with damaging effects on corporate growth. However, if equity investors think that interest rates will go up, then why not just short bonds via something like the iPath US Treasury 10-year Bear ETN (NYSEMKT: DTYS  )

Another explanation is that investors are afraid of a cataclysmic event in the future, and don't wish to hold equities. Indeed, every recent global recession seems to have been deeper than the last. Moreover, the U.S. public debt situation is such that the U.S. (and the global economy) could face a severe and lasting depression if another recession takes place in the next few years.

US Projected Government Debt data by YCharts

The third explanation is that asset classes' valuations tend to be the product of a combination of fundamentals and waves of enthusiasm that come in to the sector. It was equities in the late '90s, then property in the early 2000s, then oil and commodities, then it was gold, and now it's emerging market bonds.

The bottom line
Unfortunately, the Fed model doesn't provide a catch-all solution to asset class allocation.  Any valuation method needs to be put into the context of the overall investment environment, and while it's easy to argue that the Fed model works under "steady state" conditions (such as between 1980-2000) it's a lot harder to predict when those conditions will come about again. Investing just isn't that simple.

Protectionism on the Rise

Since the recession of 2008 the main debating point of the investment community has been over the possibility of a sustainable recovery in the global economy. However, this focus could lead many investors to be blindsided by the fact that increased protectionism has caused world trade to grow slower than global GDP. The repercussions have been directly seen in transportation plays like shipping company DryShips (NASDAQ: DRYS  ) and FedEx (NYSE: FDX  ) . Moreover, an increased climate of protectionism, led by countries such as India, also threatens prospects for companies as diverse as Cisco (NASDAQ: CSCO  ) and Pfizer (NYSE: PFE  ) .

Global trade growing slower than GDP
Over the last few months, three highly regarded institutions have highlighted the increasing growth of protectionism in the global economy. First, in an interview with CNBC television, World Trade Organization Director-General Roberto Azevedo outlined that the WTO would downgrade world trade growth estimates for 2013 from 3% to 2.5%. In addition, 2014 estimates would be cut from 5% to 4.5%. These would be done because of protectionism.

Second, the EU produced a report that highlighted a "worrying increase in the adoption of certain highly trade-disruptive measures." Interestingly, the emerging markets appear to be the worst culprits with Brazil, Argentina, and India cited in the report's conclusions.

Third, the International Air Transport Association argued that almost 500 protectionist measures were taken in 2012 alone.   Furthermore, data from the IATA clearly demonstrates that airplanes' cargo revenue and passenger revenue have diverged since the recovery took place. Cargo revenue is particularly susceptible to protectionism.

Source: IATA.

Transportation companies FedEx and DryShips affected
The immediate consequences can be seen in air cargo and transportation companies. For example, FedEx has undergone a remarkable transformation in profitability in recent years.

Source: Company presentations.

In recent years, FedEx has had to retire planes in its express segment because international express and cargo revenues have been less than hoped for.   The company still has good long-term growth prospects from e-commerce demand and its internal productivity improvement program. However, if a trade war escalates, then FedEx is likely to be a loser.

Moreover, the impact isn't restricted to air cargo. Shipping has also struggled, and a historically accurate predictor of the global economy, the Baltic dry index, has diminished in importance. The index is a measure of the shipping costs of moving raw materials. For example, here is a chart of the share price of Dry Ships vs. the Baltic dry index.

DRYS data by YCharts

Spot the correlation!

Shipping companies will be inordinately hit by a trade war, because they rely on future cash flows to at least offset the depreciation in the value of their shipping fleet.

Technology, pharmaceuticals, and consumer goods
A full-on trade war will obviously hurt the global economy, so most companies will be affected. However, smaller protectionist measures will hurt some companies more than others.

The U.S. is a major exporter of technology solutions, and Cisco is one of its leading players. Cisco just reported a very weak quarter for its emerging markets, and it's not clear if it was at least partly due to protectionist measures.

It would not be surprising if tit-for-tat measures were being taken by certain governments. In 2012, a U.S. House of Representatives report argued that Cisco's Chinese rivals Huawei and ZTE "could undermine core U.S. national-security interests," and went on to recommend that Huawei and ZTE be excluded for government work. While the U.S. may be completely justified in its actions, the potential repercussions should be considered by tech investors hoping for emerging market growth.

The pharmaceutical industry is another area of huge concern. Last year, Pfizer's chief intellectual property counsel, Roy Waldron, delivered a damning congressional testimony on the "rapid deterioration of the business environment in India." Waldron argued that India "demonstrates a flagrant disregard of patent rights." The revoking (twice) of its patents for cancer drug Sutent (while an Indian generic manufacturer launched its product on the market), and the denial of a patent to Pfizer's anticancer therapy Gleevec, were of particular concern. India stands accused of discriminating against U.S. companies in favor of supporting its own generic manufacturers, while its companies benefit from open markets in the U.S.

The bottom line
The rise in protectionism is a worrying trend in the global economy because everybody will suffer if it escalates. However, some industries will suffer more than most and long-term investors in the types of companies discussed above will need to keep an eye out for developments. In particular, countries such as India need focus more on halting their own creeping protectionism, rather than pointing fingers at others.