Enrich Your Future 09: The Fed Model and the Money Illusion

Andrew Stotz 00:02
Fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry is unique because he understands the academic research world as well as the practical world of investing. Today, we're going to discuss Chapter nine from his recent book enrich your future this keys to successful investing. This chapter is called The Fed model. And the money illusion. By the way, this wraps up part one of the book, which is how markets work. Larry, take it away.

Larry Swedroe 00:40
Thanks very much good to be back and do so in 1997. Alan Greenspan was giving a speech in front of Congress his regular report as Chairman of the Federal Reserve, and he happened to mention that some research I guess, either he or his staff have done says there was a correlation between the changes in the P E ratio and stock returns. Okay. And relative to the changes in the bond market, so somewhat makes sense, right, higher bond yields, people would think me more competition for stocks, and therefore maybe stocks can do as well. All right. Now, the problem is, first of all, one of the things we've talked about is just because there is a correlation doesn't mean that there's causation. Right? It could be an illusion of a, you know, a reason for that correlation to exist. So people form opinions, just because there is a correlation, but there may be no substance behind it. Edward, your identity was a Market Strategist for a leading Wall Street firm, took those comments, and he hypothesized that the Fed was looking at this measure. Okay, and we'll talk about it as a way to determine if the Fed thought the stock market was either under overvalued or fairly, fairly valued. I don't know why he would make that conclusion because first of all, the Fed has never made any decisions, to my knowledge, based on interest rates based upon stock prices. They make it on inflation and economic growth, not stock prices, right. So the first problem that we have with this fed model, and we'll describe it now, is they said, let's take the bond yield. Okay. And let's say the bond yield is 5%, then A, if we invert that, we get a P E ratio of 20. Right? divide five into 100. Or you can create an earnings yield, and you'd have 5% with a 20. Pe. So if stocks are trading above 20, then they're overvalued, that trading under 20. They're undervalued. So

Andrew Stotz 03:18
in other words, using the government bond rate as kind of a comparative benchmark. Right.

Larry Swedroe 03:25
And okay, because they do compete for investors, right? Yeah.

Andrew Stotz 03:29
Well, for instance, if the bond right, going back to what you said at the beginning, if the bond market, let's just imagine the bond market was yielding? Well, I have an example. That's kind of an interesting one. One of my friends went during the 2008 crisis, he gathered up all the money he could get, and he bought Icelandic bonds at a 20% yield for 20 years. And the currency of Iceland wasn't in the EU. So the currency had also collapsed completely. And his hypothesis was that he would lock in a 20% yield, yes, it would be in the local currency, but the currency was so bombed out that he felt that that currency would eventually appreciate and he would get an additional return from the currency. And so when government bond yields are super high, in theory, an equity investor, if an equity investor could lock in an equity tight return in a risk free asset, it doesn't seem like a bad idea.

Larry Swedroe 04:33
Now, except that in Iceland's case, it wasn't a risk free asset. Right for US investor, US Treasuries, you know, our riskless asset, if you're buying it to the maturity that you know, you'll have a certain dollar amount of payments. Okay, so here's the first problem as we discussed, just because there is a correlation, it doesn't mean there is causation. Right? I think we've mentioned on our calls before, you can have data mining results, like David, lean Weber, he just took a database from the UN and ran all the data and said, tell me what's the best predictor of the s&p 500. And he found out it was butter production and Bangladesh. Now, no rational person would make investment decisions on US stocks based on that, because they would understand that there's really no car, you know, causation happen. It's just if you run a million different, you know, metrics, something will show up.

Andrew Stotz 05:47
That's also before that 20 years before it was the length of skirts of many Scots, as I recall.

Larry Swedroe 05:54
And then there are which was in the NFL, the original NFL teams, or the AFL teams, for American professional football won all this kind of nonsense. And

Andrew Stotz 06:05
that's one of the things that you highlight in your book about factor investing, is it the factor has to make logical sense. Yep.

Larry Swedroe 06:13
Exactly. For you to have confidence in. Right. Okay. So that's the first problem. And what happened is, when you're Danny made this hypothesis, you will hear this quoted all the time, even though the Fed never acknowledged it. And we know the Fed doesn't make decisions on it. But there is seemingly some logic if you don't have a good understanding of economics, and just some simple understanding of economics creates an understanding to so why this is what is called the money illusion, or at least I've used that term here, but others have as well. And we'll walk through why that's the case, because it's an illusion, because you're comparing two things that don't have the same impact from inflation. Okay, so nominal bonds, which is what we're comparing the P E ratio to, right, we're going to compare it to say, a 10 year or a 20 year treasury bond, and see what that so nominal bonds are impacted by rising or falling inflation, and you're seeing nominal bond yields, nominal bond yields, and then of course, the prices, if you get rising inflation, then what happens, then the yield has to go up and the price goes down. If you get fooling inflation, or inflation below what was expected, then yields will tend to fall. But stocks that should have no impact. And here's why. Because we do know that over the long term, not in this short term, but over the long term, and this is something we've discussed before, as well. That corporate earnings are aligned with nominal GNP growth, which makes sense, if, for example, we think on average, corporations earn 10% of all of the GNP as profits, then higher inflation pushes the nominal GDP up, and it will push corporate profits up. Right. So if let's take

Andrew Stotz 08:39
the underlying thing to, if we just go at a very micro level, companies, management teams, when they get rising prices into their rising raw material prices, they're doing everything they can to try to either become more efficient to absorb those rising prices and maintain their margin, or they're going out and raising the price on of their final product. And therefore, you could think of a corporate corporations generally is passing through inflation not absorbing it. Now,

Larry Swedroe 09:15
we know roughly US corporate profits have gone up something like 6% A year 3%, GNP growth 3% inflation, no magic, so corporate earnings should move with the real rate of interest, not the nominal rate of interest. And so let's walk through this example. So let's assume that we expected GNP growth of 2% and 3% inflation. So what would you expect that roughly the long term treasury bond is going to yield 5% 5% right now that would say under this fed model rule, that that fair value of the s&p or the market would be a 20. Pe. Okay. Now, if interest rates fell to four, right, what would be the fair value? Only five, when he thought now let's see if that makes any sense. Now, some people say, well, I already that's obviously makes sense, we now have less competition, because yields are only four. So stock prices could should be higher. But that's completely illogical, because it fails to account for the fact that corporate earnings are impacted by inflation and or GNP growth. So how do we get the yield? Going from five to four, one of two ways, either it's inflation going down. So if inflation goes from three to two, we would expect the yield go to four. But what's going to happen to corporate earnings? in nominal terms, il GM down 1% cousin, flesh in is less, right. Now let's look at the other side of that coin. And let's say yields go down, because real GNP is falling. In this case, let's say it went to 1%, not two, right? So now you'd have one plus 3%, inflation, you'd have four, well, what's going to happen to corporate earnings, if the economy is slower, they're gonna slow. And we know that in the long term, they move pretty much in line with each other. So to

Andrew Stotz 11:38
summarize what you've said, what you're saying is that we have two factors that can be considered, it's either a change in expectations about inflation, or changing expectations about real GDP growth, and both of these things would have a direct impact on corporate earnings, it's going to corporate earnings is going to come down, whether it's inflation or a slowing economy. Right. Now,

Larry Swedroe 12:08
let's show you the other side to show you how silly it is that people believe in it. And you still even hear this quoted fairly frequently on Bloomberg or CNBC. So let's say we get a stronger economy for whatever the reasons, right could be fiscal stimulus could be, you know, tax policies change regulatory rules, the economy is doing better. It's coming out of recession, companies are restocking building inventory or hiring. Right? What happens to demand? Right, so companies have to hire people, unemployment goes up, wages, go up, inventories, get stock, get investment, what happens is the demand to borrow goes up. So interest rates go up, well, gee, we corporate earnings are going up. So why should stock prices be lower, they really have this competition between the two, just because you have rising interest rates, doesn't mean that the market is now you know, undervalued or not fairly valued. Or in this case, it would be overvalued, right, because of the higher rates. So you have to look at both pieces of the coin.

Andrew Stotz 13:28
So let me just summarize that just to what you're basically saying is that interest rates on government bonds would go down from let's say, five to 4%. And then the interest rates would go up from 5%, or some four or five?

Larry Swedroe 13:49
Well, let's go this way. Let's start at three 2%, real and 3%. Inflation, okay, let's say we now get a stronger economy, right? So we get 3% growth instead of two, what's gonna happen to the look, you know, the long bond is going to jump to six. But so that means the P E ratio should be 16.7. Why, Let's, first of all, the risk premium for stocks should be going down, right? Because the economy's strong, the less companies that go bankrupt, corporate earnings are going to be higher. So why should the stock market go down? Just because yields are rising. In fact, we have a perfect example of that. In the last three years or so or two years, since the Fed started raising interest rates, what's happened to the stock market? Now, I'll show you one of the interesting thing to show you how silly this idea of the Fed model is, and yet gets quoted by Market Strategist and others often and investors tend to believe it. What At the peak of the or the bottom of the recession caused by COVID, Treasury longer bonds were yielding, let's say 1%. What should be a fair value? P E ratio under the Fed model?

Andrew Stotz 15:15
B's 100? What is it? 100?

Larry Swedroe 15:17
Does anybody think that makes any sense? No. Right? So it can't be right. And yet, so many people leave, let's sort of summarize it, the real work you have to look at is, you know, the research here, and Cliff Asness er, did a paper and he looked at this relationship between nominal yields and stock return, and there wasn't any it doesn't exist. So why your identity and others quoted when it's not in the research, either, there's no evidence to support it. And we just gave a great example, right? In the last two years, okay. But we do know that real interest rates matter. And so we look at the K 10. And look at real earnings over the longer term, right? And what when you invert the cake, 10, suffocate 10. Today, let's say is 30. We know that that's telling us that the expected real return to stocks is 3.3%. So we're now looking at a real number. And then you could compare that to the yield on tips, another real number, and you can make a decision based upon your own ability, willingness and need to take risk, whether you want on stocks on Is there a big enough risk premium, if the cape 10 is 30. Today, so you'd have 3.3% earnings yield and tips yields out that far, let's say 2%, while you're only getting a 1.3%, equity risk premium relative to tips, and you have to decide whether that's an appropriate return for you to take the risk of equities. So

Andrew Stotz 17:17
just to go back to the Cape ratio, which is generally we would say, the price today, relative to the average earnings over the past five or 10 years adjusted for

Larry Swedroe 17:29
inflation. Right, same thing for inflation. So it goes back 10 years, let's say, the 10 years ago, inflation since then was 40% of companies earned $100. They would call it 140. So inflation adjusted to bring it make it like a real earnings number, right? And then it averages it to take out the cyclicality, right. And that now you're using the real number in earnings, right? And a real number. You then could compare it to the tips yield, and look at that. But also, when the Fed model doesn't say anything notice about the expected return for stocks. All it said, even though it's wrong was that stocks were either under a fairly bad so people could, in theory use it to time the market. Right? It didn't tell you anything about future stock returns where the cape 10 has about a 40% explanatory power, which is pretty high, gives you out but again, you can't even use that to try to time the mock, you would have done very poorly over the last 3040 years trying to use it.

Andrew Stotz 18:58
You know I? I've looked at the Cape 10 For many years, and I didn't realize it was ingested for inflation. The earnings are adjusted for inflation. Yeah. And I'm just looking at it now. And I see that so yeah, that's really helpful. Well, that's quite a wrap up on this first section. You know, I think it's just important to kind of go back and think about what we've talked about in this part one of how markets work, because we were looking at how security prices are determined why it's so difficult to outperform. Right? We looked at risk and return on stocks and bonds. We looked at how markets set prices, we looked at persistence of performance and for why it's hard to outperform, you know, and just the competitive nature of what you're competing against when you enter the market you're competing against, you know, the best wisdom all accumulated into today's price. You've also told us about how great companies don't make high return investments and market efficiency. As we talked about Pete Rose, and just again, how hard it is. And we saw the value of security analysis, which I'm sorry to say, doesn't add value, unfortunately. And then we talked about last time, be careful what you ask for now, we're trying to understand that Be careful, particularly understand the way I think about the Fed model. And the money illusion is make sure you clearly understand the difference between real and nominal, number one. And number two, also clearly understand that a corporate earnings, basically, whether it's real GDP or inflation, it's going to match those. So it's sort of a pass through it is ultimately the economy and the GDP. So is there anything you would add to all of that summer?

Larry Swedroe 20:47
Yeah, let me add one other comment, just to make sure the audience doesn't think security hours as analysis has no value, it has no value in your ability to outperform the market. Because we don't know we can't identify the analysts who can predict better than the collective wisdom of the market. But security and our analysis adds tremendous value, because their insights help inform stock prices. And that tells you how capitals should be allocated. Right? If companies were overvalued, because people were misjudging the future and overestimating, in general, a company's ability to generate earnings, then capital would get allocated efficiently to bad industries, like happens in communist countries. But not to happen here. So the value is in there seeking information and trying to find the right price. They are in fact making the market efficient. It's their efforts in setting prices. That really makes markets work. It's just the competition is so odd, that be the collective wisdom of the market. Yeah,

Andrew Stotz 22:06
and I guess the way one way to think about that is the extremes. Let's go back in time where there were no passive funds, it was all active. And let's go forward in time, and imagine that we were all passive 100%, there are no analysts anymore. Both of those extremes are not the best outcome for the overall market. Because, you know, all the things that we've talked about, right?

Larry Swedroe 22:29
Now, the one thing you obviously it's never going to happen, that won't be they'll always be active investment. But even if they're Warren, that still be stocks traded, because people die. And they asked us after be sold, they need to live. We also have companies buying other companies. Excuse me. So there will always be some training, but we need active managers. So we have to keep it a secret that passive management is the winning strategy. We need those active guys to keep the market one liquid, keep trading costs down, and they make the market efficient. So we become free riders and don't have to pay their expenses. We'll let the people playing the losers game. Let them bear all the expenses of those animals.

Andrew Stotz 23:20
Oh, okay. And on that note, let's just briefly look at Part Two of the book, which is strategic portfolio decisions in our next chapter, chapter 10. Is when even the best aren't likely to win the game. But just you know, what, what should we expect in the strategic portfolio decisions? Part two of the book?

Larry Swedroe 23:40
Yeah, so there's a whole topics here about helping you decide what is the winning strategy, active or passive investing? And why is that true? And looking at thinking about what I call the difference between risk and uncertainty. Risk is where like throwing the dice, you know, exactly the odds. Risk is also or at least very close to risk life insurance companies who can estimate using demographic data? The odds of a 65 year old couple seconds of die life expect Snop perfect, right? They can't know what future science inventions can extend life, whether we have a global pandemic that might shorten it, but they can make good estimates, right. But uncertainty is things like an oil embargo or nuclear war. You know, things like that or COVID incident. There's no way to estimate those things. So you have to look at what tail risk can come up. And how do you insulate a portfolio as best you can or inch Are you against that tail risk of those things? And how do you build a portfolio? Knowing that there are no crystal balls that allow you to foresee the future? Yeah,

Andrew Stotz 25:11
it's exciting because you know, we've kind of set the foundation in your first part of the book. And now we're going to think about the application of constructing the portfolios. And I like in the end of the part two, you're talking about, you know, what, how do we need to think about, you know, black swan events? You know, as you mentioned, there can be some very extreme things, and also questions about gold. And I know, You've recently done some work on that, which was really interesting to read. So I'm excited for that section. So Larry, I want to thank you again for this great discussion. And I'm looking forward to that next check section in the next part of the book. And for listeners out there who want to keep up with all that Larry's doing. Just follow them on Twitter at Larry swedroe. Or on LinkedIn. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.