July 29, 2002

According to the press, the Fed has a simple model that spits out where the market should be at any given time. The simple construct compares the bond market yield to the earnings yield of the stock market (i.e., the inverse of the P/E ratio). Recently the model has gained currency and many analysts and forecasters are using a variant of the model to determine the markets fair value. Some economists have argued that currently the market is undervalued to the tune of 40%. Whether the market is under or overvalued is an elusive question. If the economy grows at a 3% rate and the earnings re-statements amount to approximately 15% of the S&P 500 we would argue the market is fairly valued. A stronger GDP growth rate or smaller restatement would make us bullish, although no where near the 40% undervaluation mark. (full article attached)

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