So last time at this exam I had a grasp on the logical reason why if:
The SnP earnings yield is above treasuries and
in Yardeni if the Market Earnings yield is above the Yardeni intrinsic, its equals undervlaued equities.
I cannot for the life of me make intuitive sense of it right now, anyone care to clear it up for the rest of us? I’d rather not just memorize, but make sense of it.
Thanks…
The Fed Model ignores the equity risk premium i.e. it assumes the risk of equities (S&P index) is equivalent to LT-treasuries. Therefore, it believes the earnings yield on equities should be equal to the yield on treasuries in the long run. So if equities are yielding more than treasuries, even though they have the same risk (according to the Fed model), there’s an opportunity for risk-adjusted profits in the equity markets. Equities are underpriced! Why? As yield goes up, price goes down. Equity yield is higher than what it should be, so its price is lower than what it should be. Undervalued!
This only makes sense if we ignore the equity risk premium of course.
Aaaah ok, so prices need to go up to lower the yield…I knew it was something simple like that…
Ed Yardeni showed in his model that E1/Po = Yb - d * LTEG , model where E1 is the future earnings , fair value P0 of current price , Yb is the bond yield , LTEG is the long term expected growth rate ( 5 years ) as per analyst estimates from Reuters and d is a coefficient empirically found to be 0.1 .
Re-arranging
Po = E1 / ( Yb - d * LTEG)
so the fair value should be as this equation shows …
Now it is simple to conclude that if the actual current price is higher , then the Equities market is overvalued . If the actual current price is lower , then the Equities market is undervalued .
Thinking about yield works for me. When s&p 500 earnings’ yield is higher in yardeni’s model, [it’s good], it implied that the price is too low. In other words, the equity market is undervalued.
another way to think about this -> a higher return requirement - would cause cash flows to be discounted at the higher rate - so the price would be low – undervalued. A lower rate - would cause the price to increase. (using the DDM).
Higher interest/discount rate, lower price valuation. Hence, higher E/P (assuming market earnings remain constant)? In addition, since interest rates are higher, investors tend to flock over to treasuries pulling the equity prices even lower. Am I understanding this correctly?
Hmm I’m not sure I’m following you. The Yardeni model compares its “justified” earnings yield to the market earnings yield. If the justified yield per the Yardeni model is higher than the market earnings yield, it is saying that the market earnings yield needs to rise, which in turn means market prices need to fall (yield is always inversely related to price), thus the market is currently overvalued in price terms. The reverse is true of course, and the market is fairly valued if the yields are equal.
Sorry, I was pertaining to the Fed Model.