Is the Fed Model a useful market timing tool? In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion”, Robert Weigand and Robert Irons investigate whether very high price/earnings (P/E) ratios foreshadow poor future stock market performance. Using data over the very long period from 1881 to 2002, they find that:
- At high starting P/E ratios (21 and above), stocks deliver 10-year real returns in line with their long-term historical average. These high P/E periods are associated with the highest rates of real earnings growth on record.
- Prior to 1960, the P/E ratio reverts to its long-term mean of 14 with almost predictable regularity. Since 1960 (approximately the time that investors began using the Fed Model), market E/P ratios and bond yields have tracked closely. There may be no reason to fear bear market returns expected to accompany high P/E ratios.
- On a note of caution, investors could abandon their belief in the Fed Model when interest rates begin rising, decoupling the longstanding relation between market earnings yields and interest rates.
In summary, the Fed Model has worked pretty well starting about 1960, with interest rates since playing a key role in stock valuation.
