Today I want to share with you an my latest Institutional Investor article (an excerpt is below) on some important but quite boring topics that include the Fed Model, the price-to-earnings ratio, and profit margins. I imagine for most civilians (people who don’t do investing for a living) reading about these topics is as exciting as watching a live debate between two paleontologists about how the size of tyrannosaurus' front teeth relates to the length of spinosaurus’ tail. (I have no idea what I just wrote.)

I will have you know, however, that the Fed Model is extremely important, because I vividly remember how low interest rates and the Fed Model were used as propaganda tool in the late '90s to justify the stock market’s “this time is different” sky-high valuation. Low interest rates have been pushing investors into riskier assets and have thus resulted in higher valuations, but just as you would expect a finite boost of energy from 5-Hour Energy drink, low interest rates will not bring permanently higher valuations in stocks.

I see an army of experts on business TV – and non-experts in day-to-day dealings – justify holding otherwise overvalued stocks by comparing their yields of 2% or 3% to the yields of bonds. Stocks and bonds are competing assets, so a low yield in bonds in the short term (a key distinction) will drive higher P/Es (lower earnings yields) in stocks. But today, rather than a race to the top we have a race to the bottom. As bonds yields rise (or not – if they don’t it means we're in deflation, which is even worse) stock valuations will return to their rightful place – lower. Of course there is a caveat: they may go a lot higher before they do that. But that's investing for you.

I have written the topic of profit margins half to death; I even penned a scribble for Barron’s, discussing them back in 2008. All you have to do is look at the historical charts (see this chart) – profits always mean-revert. Mean reversion of profits is so banal it should be taught in finance classes just as Newton’s law of gravitation is taught in physics. Earnings have never grown at a faster rate than GDP (sales of the economy) for a substantial period of time. This time is not different. I’d buy an argument that the long-term mean of profit margins may have shifted upwards over the last two decades as we have become more of a service and less of a manufacturing economy. So instead of being at 8% – or maybe it should be closer to 9% – we are in the mid-teens.

The Not So Big Picture On Financial Markets

Rarely do I disagree with fellow investor and financial blogger Barry Ritholtz, but the time has finally come. Last week Barry wrote a column for Bloomberg View called “Why ‘Peak-Earnings Models’ Are Nonsense.” Though I don’t agree with everything I read, and I hardly ever expend the energy to write a long response, this time I saw an opportunity to discuss several important topics: the Fed model (where Barry and I actually agree) and profit margins and the P/E model (where we disagree).

In his article Barry argues that the Fed model is flawed because it compares two variables — valuations implied by interest rates (the inverse of the ten-year Treasury yield) and actual valuations, market price-earnings — to tell you whether stocks are cheap or expensive. Barry writes, “The problem with the formula is that it contains not one but two variables. ... Hence, the Fed model tells you one of two things: Either equities are over/undervalued, or consensus earning estimates are either too high or too low.”

I agree that the Fed model could be telling you that stock valuations are too low or too high in relation to interest rates, but this assumes that interest rates are at the right level and will be at this level in the future. Current interest rates could be too high or too low as well, especially in an environment in which governments globally set the levels of short- and long-term interest rates, rather than letting the market do it. Also, the Fed model confuses an intuitive relationship (that is, higher interest rates lead to lower P/Es and vice versa) with a direct relationship.

To continue reading the full article, click here.