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Stock Strategist

A Better Way to Value the Stock Market

Introducing the new Morningstar median price/fair value ratio.

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Last week, I highlighted a common method for valuing the stock market called the Fed Model. The essence of this model is that it compares the interest yield on 10-year Treasury bonds to the 12-month forward earnings yield for the stock market. The forward yield on the stock market is currently between 4.5% (using economists’ estimates of 2004 S&P 500 earnings) and 5.2% (using Wall Street analyst estimates of S&P 500 earnings), and the yield on the 10-year Treasury note is 4.05%. According to the Fed Model, then, stocks would have to rise 12% to 34% from their current level to get to fair value.

However, if interest rates rise to a level anywhere near their long-term average (6% or so), stocks will suddenly appear overvalued by the Fed Model. No one can predict where interest rates will go, of course. For this reason, I came to the conclusion that the Fed Model is much better at explaining past market valuations than predicting future ones (unless you are able to predict interest rates).

Mark Sellers does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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