April 15, 2002

According to street lore, the difference between the stock market earnings yield (i.e. the inverse of the P/E ratio) and the yield of the 10-year T-Bond is the way that Alan Greenspan decides whether the market is overvalued or undervalued. An earnings yield below the T-Bond yield signals an overvalued market. Conversely, an earnings yield above the T-Bond yield signals an undervalued market. Inverting the two variables makes the market valuation condition easier to interpret. This interpretation of the Fed's model is commonly known as the "Capitalized Earnings Model." Looking back, anyone following the Capitalized Earnings Model would have been fully invested during the greatest bear markets of the post-war and would have missed one of the greatest bull markets of all times. Elegant or not the Capitalized Earnings Model gives lousy investment advice. (full article attached)

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