The 'Fed model' is warning us to be careful

Stocks have had a fantastic run-up. The rally of the past year or so has been nothing short of spectacular. But now it's time for investors to be cautious and pull in their horns.

"Come on", you say. "Pundits have been predicting a crash since the start of the rally. Why should we pay any attention now?"

I'll tell you why. Because the 'Fed model', which issued a 'buy' signal for stocks back in early 2009, is now saying it's time to get defensive again.

What is the Fed model?

The Fed model compares relative value between stocks and bonds. Take the earnings yield (earnings per share divided by share price) on the FTSE and compare it with the yield (what you get as a dividend) on the local ten-year government bonds (gilts, in our case).

When the earnings yield on a stock index is higher than the benchmark bond yield, stocks are attractive. And when the bond yield is higher than the earnings yield, investors should opt for bonds.

The system's founder Ed Yardeni (then chief strategist at Deutsche Bank) created a sliding scale. In it, a portfolio of stocks and bonds is weighted in favour of the cheaper asset. The magnitude of the stock or bond bias depends on just how cheap either asset is.

Why the Fed model matters

Simple, eh? Too simple for some. An intellectual snobbery tends to cloud opinion of the Fed model. Detractors claim that the 13-year old approach failed to warn us of the credit crunch. They decry that the bond half of the Fed model doesn't take account of inflation, while the stock half (by default) does. And they say that the Fed model's ranking of stock and bond yields alone is arbitrary in the real world, as stocks and bonds are not the only options available to investors.

But this misses the point. The Fed model matters because important people use it. Analysts across the board, from JP Morgan, to ING, to Prudential I could go on and on use the Fed model in their calculations.

Some make amendments to the basic formula for example ING's take on the Fed model factors CPI inflation into the bond yield but the idea remains the same.

The fact is, influential market players embrace the Fed model. Whether they truly believe in it or not is immaterial. The net result is that the Fed model is a significant valuation tool which prominent investors use to check whether they should be buying stocks or bonds.

And when those inflection points come about, markets move. Because when the advocates say it's time to buy, a wave of trading orders are placed.

The Fed model works

If you look at its past history, you can see the power of the model:

Stock prices crashed after the market rose to a (then) record over-valuation (compared to bonds) in 1987.

During both the summers of 1997 and 1998, over-valuations were corrected by a sharp drop in prices.

Then a two-month undervaluation condition during September and October 1998 was quickly reversed as stock prices soared to a remarkable record Fed model over-valuation in January 2000. This bubble was led by the Nasdaq and technology stocks, which crashed over the rest of the year, bringing the market closer to fair value.

I have a personal success story thanks to it. In 2009, it guided me to recommend my subscribers (in The Fleet Street Letter) to "Buy! Buy! Buy!" That recommendation came 17 January 2009, anticipating last year's record run in stock prices.

The Fed model is warning that it's time to get defensive

JP Morgan's Eduardo Lecubarri says "opportunity is still plentiful at the stock level". In other words, it's a stock picker's market. If you're looking for clues, Lecubarri's research shows overwhelmingly that it is large caps as many as 84.7% of European large caps that are "attractive on the Fed Model".

Blue chips might prove a wise choice Simon Goodfellow, also a Fed model follower, concurs. "The market is ripe for a correction," the ING strategist recently told CNBC Europe. As a potential remedy, Goodfellow believes that large-cap US stocks have good earnings prospects and defensive characteristics. This is an area of the market in which the Fleet Street Letter currently has open recommendations.

These are people that have been right before, and they seem to be on the right track again.

Remember, we're in this game to make money, not to win theoretical debates.

Never mind what the sceptics have to say. For the pragmatic investor, the worthiness of a strategy should be judged on its success rate. The Fed model worked for me in 2009 and now it says it's time be more cautious.

Theo Casey is investment director of the Fleet Street Letter.