Larry Swedroe is well-known to many investors and financial professionals as a source of common-sense investment wisdom. Wise Investing Made Simpler (CFPN, 2010) is the follow-up to Swedroe’s Wise Investing Made Simple (CFPN, 2007), and continues the author’s efforts to expose the misconceptions many investors have about financial markets through anecdotes and empirical data. Below is an excerpt containing Chapters 10-12. Wise Investing Made Simpler hit shelves in June 2010.
Chapter 10
The Fed Model And The Money Illusion
Magic, or conjuring, is the art of entertaining an audience by performing illusions that baffle and amaze, often by giving the impression that something impossible has been achieved, as if the performer had supernatural powers. Practitioners of this art are called magicians, conjurors or illusionists. Specifically, optical illusions are tricks that fool your eyes. Most magic tricks that fall into the category of optical illusions work by fooling both the brain and the eyes together at the same time.
Fortunately, most optical illusions don’t cost the participants anything, except perhaps some embarrassment at being fooled. However, basing investment strategies on illusions can lead investors to make all kinds of mistakes.
There are many illusions in the world of investing. The process known as data mining—torturing the data until it confesses—creates many of them. Unfortunately, identifying patterns that worked in the past doesn’t necessarily provide you with any useful information about stock price movements in the future. As Andrew Lo, a finance professor at MIT, points out: “Given enough time, enough attempts, and enough imagination, almost any pattern can be teased out of any data set.”1
The stock and bond markets are filled with wrongheaded data mining. David Leinweber, of First Quadrant Corp., illustrates this point with what he calls “stupid data miner tricks.” Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh.2 His example is a perfect illustration that the mere existence of a correlation doesn’t necessarily give it predictive value. Some logical reason for the correlation to exist is required for it to have credibility. For example, there is a strong and logical correlation between the level of economic activity and the level of interest rates. As economic activity increases, the demand for money, and, therefore, its price (interest rates), also increases.
An illusion with great potential for creating investment mistakes is known as the “money illusion.” The reason it has such potential for creating mistakes is it relates to one of the most popular indicators used by investors to determine if the market is under- or overvalued, what is known as The Fed Model.
The Fed Model
In 1997, in his monetary policy report to Congress, Federal Reserve Chairman Alan Greenspan indicated that changes in the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming 12 months have often been inversely related to changes in long-term Treasury yields.3 Following this report, Edward Yardeni, at the time a market strategist for Morgan Grenfell, speculated that the Federal Reserve was using a model to determine if the market was fairly valued—how attractive stocks were priced relative to bonds. The model, despite no acknowledgment of its use by the Fed, became known as the Fed Model.
Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the E/P ratio (the inverse of the popular price-to-earnings, or P/E, ratio). For example, if the yield on the 10-year Treasury were 4 percent, fair value would be an E/P of 4 percent, or a P/E of 25. If the P/E is greater (lower) than 25, the market is considered overvalued (undervalued). If the same bond were yielding 5 percent, fair value would be a P/E of 20. The logic is that higher interest rates create more competition for stocks, and this should be reflected in valuations. Thus, lower interest rates justify higher valuations, and vice versa.
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