FYI | Aug 23 2010
By BTIG market strategist Mike O'Rourke
A week ago, we highlighted the slow volume behind that sell off. Despite an option expiration, this last week became the new slowest week of the year. Equity volumes of the past couple of weeks have been running 24% below the averages for all of 2010, and 33% below the average daily volume in Q2 when the spring swoon occurred. The next two weeks only portend to be slower, but should certainly be more interesting with the large amounts of economic data due to be released. The data flow starts with the Existing Homes data on Tuesday and carries through to the Employment Situation report just prior to the Labor Day holiday.
When we shifted back to a bullish stance in mid-July after a 2 ½ month respite in Neutral, among one of the factors we cited was the “BTIG Fed Model.” The premise of the traditional Fed Model is that the S&P 500 earnings yield and the 10 year Treasury yield historically trend together over time. The term “Fed Model” was given to this relationship by Ed Yardeni in 1997 after seeing a chart of the relationship in the Fed’s Humphrey Hawkins Report. During the low interest rate environment of the past decade, the Fed Model has fallen out of investor focus. The reason is the model has shown equities as undervalued during nearly all of the decade, and as the Great Recession gained momentum, equities became significantly more undervalued. The logic behind the long term relationship makes sense because these are two very popular asset classes that compete with one another for investor dollars. Based upon the relative outperformance of one versus the other, investor dollars are reallocated regularly.
The “BTIG Fed Model” attempts to place a more conservative and defensive twist on the traditional Fed Model. When the levels of risk and fear rise in the financial market, Treasury Bonds represent the safe haven for investors and Equities are a proxy for risk. Thus, Treasuries become expensive relative to Equities, but that heightened level of risk is the obvious reason for that shift. In order to account for the fear risk, in the BTIG Fed Model, we use the Vix in conjunction with the 10 Year Treasury Yield to raise the threshold with which Equities must compete. During these episodes of heightened fear, the Vix traditionally moved inversely with the 10 year Treasury yield. The Vix rises with the volatility and Treasury yields contract due to a flight to quality. Thus by taking the Vix and dividing by 10 and adding it to the 10 Treasury yield, we derive a larger number representing bonds not only reflecting the expected cash flow, but also adjusting for the heighted level of risk investors perceive in equities. Then comparing this “higher bar” to the S&P 500 earnings yield, one is comparing this relationship on a more conservative basis for equity investors. Additionally, we are using trailing S&P 500 earnings yield, which is also more conservative than using forward estimates.
What is extremely noteworthy about this metric in the current environment is that the level of equity undervaluation relative to Treasuries today using this model is equivalent to the extreme levels registered in early March of last year (Chart 1). The improvements for equities are on all fronts. As we noted last week, Treasury yields today are lower than they were at the equity market bottom. The Vix is at one half its level of March 2009 (simultaneously, it is not low either) and very importantly, corporate earnings have mustered an incredible rebound. We are asserting that on a risk adjusted basis, the environment for equities versus bonds today is the equivalent to that of early March 2009. The improvement in the standing of equities in this relationship will likely come from reversions on both sides – equities rallying and bonds selling off. While there are no guarantees that equities will not get cheaper, this certainly indicates the odds of success are much greater for investors who are on the bid side of the equity market.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
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