Asset Valuation Allocation Models
R e s e a r c h
July 30, 2002
Dr. Edward Yardeni
(212) 778-2646
ed_yardeni@prusec.com
Amalia F. Quintana
(212) 778-3201
mali_quintana@prusec.com
Asset Valuation & Allocation
Models
- Introduction I. Fed’s Stock Valuation Model
How can we judge whether stock prices are too high, too low, or just right? The purpose
of this weekly report is to track a stock valuation model that attempts to answer this
question. While the model is very simple, it has been quite accurate and can also be used
as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after
reading that the folks at the Federal Reserve have been using it. If it is good enough for
them, it’s good enough for me. I dubbed it the Fed’s Stock Valuation Model (FSVM),
though no one at the Fed ever officially endorsed it.
On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board,
famously worried out loud for the first time about “irrational exuberance” in the stock
market. He didn’t actually say that stock prices were too high. Rather he asked the
question: “But how do we know when irrational exuberance has unduly escalated asset
values, which then become subject to unexpected and prolonged contractions….”1 He did
it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market
valuation model to help him evaluate the extent of the market’s exuberance. Apparently,
they did so and it was made public, though buried, in the Fed’s Monetary Policy Report
to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on
July 22, 1997. 3
The Fed model was summed up in one paragraph and one chart on page 24 of the 25page document (see following table). The chart shows a strong correlation between the
S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E)
to the price index for the S&P 500 companies (P), using 12- month-ahead consensus
earnings estimates compiled by Thomson Financial First Call.—and the 10-year Treasury
bond yield (TBY). The average spread between the forward earnings yield and the
Treasury yield (i.e., FEY-TBY) is 29 basis points since 1979. This near-zero average
implies that the market is fairly valued when the two are identical:
1) FEY = TBY
Of course, in the investment community, we tend to follow the price-to-earnings ratio
more than the earnings yield. The ratio of the S&P 500 price index to expected earnings
(P/E) is highly correlated with the reciprocal of the 10-year bond yield, and on average
the two have been nearly identical. In other words, the “fair value” price for the S&P 500
(FVP) is equal to expected earnings divided by the bond yield in the Fed’s valuation
model:
2) FVP = E/TBY
1
http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm
“We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the
current environment to keep this question on the table.”
http://www.federalreserve.gov/boarddocs/hh/1997/february/testimony.htm
3
http://www.federalreserve.gov/boarddocs/hh/1997/july/ReportSection2.htm
2
Page 2 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
Excerpt from Fed’s July 1997 Monetary Policy Report:
The run-up in stock prices in the spring was bolstered by unexpectedly strong
corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to
consensus estimates of earnings over the coming twelve months has risen
further from levels that were already unusually high. Changes in this ratio have
often been inversely related to changes in long-term Treasury yields, but this
year’s stock price gains were not matched by a significant net decline in interest
rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of
twelve-month-ahead earnings to prices by the largest amount since 1991, when
earnings were depressed by the economic slowdown. One important factor
behind the increase in stock prices this year appears to be a further rise in
analysts’ reported expectations of earnings growth over the next three to five
years. The average of these expectations has risen fairly steadily since early
1995 and currently stands at a level not seen since the steep recession of the
early 1980s, when earnings were expected to bounce back from levels that were
quite low.
The ratio of the actual S&P 500 price index to the fair value price shows the degree of
overvaluation or undervaluation. History shows that markets can stay overvalued and
become even more overvalued for a while. But eventually, overvaluation is corrected in
three ways: 1) falling interest rates, 2) higher earnings expectations, and of course, 3)
falling stock prices—the old fashioned way to decrease values. Undervaluation can be
corrected by rising yields, lower earnings expectations, or higher stock prices.
The Fed’s Stock Valuation Model worked quite well in the past. It identified when stock
prices were excessively overvalued or undervalued, and likely to fall or rise:
1) The market was extremely undervalued from 1979 through 1982, setting the stage
for a powerful rally that lasted through the summer of 1987.
2) Stock prices crashed after the market rose to a record 34% overvaluation peak during
September 1987.
3) Then the market was undervalued in the late 1980s, and stock prices rose.
4) In the early 1990s, it was moderately overvalued and stock values advanced at a
lackluster pace.
5) Stock prices were mostly undervalued during the mid-1990s, and a great bull market
started in late 1994.
6) Ironically, the market was actually fairly valued during December 1996 when the
Fed Chairman worried out loud about irrational exuberance.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 3
7) During both the summers of 1997 and 1998, overvaluation conditions were corrected
by a sharp drop in prices.
8) Then a two- month undervaluation condition during September and October 1998
was quickly reversed as stock prices soared to a remarkable record 70%
overvaluation reading during 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
II. New Improved Model
The FSVM is missing a variable reflecting that the forward earnings yield is riskier than
the government bond yield. How should we measure risk in the model? An obvious
choice is to use the spread between corporate bond yields and Treasury bond yields. This
spread measures the market’s assessment of the risk that some corporations might be
forced to default on their bonds. Of course, such events are very unusual, especially for
companies included in the S&P 500. However, the spread is only likely to widen during
periods of economic distress, when bond investors tend to worry that profits won’t be
sufficient to meet the debt-servicing obligations of some companies. Most companies
won’t have this problem, but their earnings would most likely be depressed during such
periods. The FSVM is also missing a variable for long-term earnings growth. My New
Improved Model includes these variables as follows:
3) FEY = CBY – b · · LTEG
where CBY is Moody’s A-rated corporate bond yield. LTEG is long-term expected
earnings growth, which is measured using consensus five- year earnings growth
projections. I/B/E/S International compiles these monthly. The “b” coefficient is the
weight that the market gives to long-term earnings projections. It can be derived as [FEY-CBY]/LTEG. Since the start of the data in 1985, this “earnings growth coefficient”
averaged 0.1.
Equation 3 can be rearranged to produce the following:
4) FVP = E ¸ ¸ [CBY – b · · LTEG]
FVP is the fair value price of the S&P 500 index. Exhibit 10 shows three fair value price
series using the actual data for E, CBY, and LTEG with b = 0.1, b = 0.2, and b = 0.25.
The market was fairly valued during 1999 and the first half of 2000 based on the
consensus forecast that earnings could grow more than 16% per year over the next five
years and that this variable should be weighted by 0.25, or two and a half times more than
the average historical weight.
III. Back To Basics
With the benefit of hindsight, it seems that these assumptions were too optimistic. But,
Page 4 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
this is exactly the added value of the New Improved FSVM. It can be used to make
explicit the implicit assumptions in the stock market about the weight given to long-term
earnings growth. The simple version has worked so well historically because the longterm growth component has been offset on average by the risk variable in the corporate
bond market.
IV. Stocks Versus Bonds
The FSVM is a very simple stock valuation model. It should be used along with other
stock valuation tools, including the New Improved version of the model. Of course, there
are numerous other more sophisticated and complex models. The Fed model is not a
market-timing tool. As noted above, an overvalued (undervalued) market can become
even more overvalued (undervalued). However, the Fed model does have a good track
record of showing whether stocks are cheap or expensive. Investors are likely to earn
below (above) average returns over the next 12-24 months when the market is overvalued
(undervalued).
The next logical step is to convert the FSVM into a simple asset allocation model
(Exhibit 1). I’ve done so by subjectively associating the “right” stock/bond asset mixes
with the degree of over/under valuation as shown in the table below. For example,
whenever stocks are 10% to 20% overvalued, I would recommend that a moderately
aggressive investor should have a mix of 60% in stocks and 40% in bonds in their
portfolio.
Bonds/Stocks Asset Allocation Model
More than 30% overvalued
20% to 30% overvalued
10% to 20% overvalued
10% undervalued to 10% overvalued
10% to 15% undervalued
More than 15% undervalued
70% bonds, 30% stocks
50% bonds, 50% stocks
40% bonds, 60% stocks
30% bonds, 70% stocks
20% bonds, 80% stocks
10% bonds, 90% stocks
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 5
70
60
80
ED YARDENI’S ASSET ALLOCATION MODEL: BONDS/STOCKS*
(for Moderately Aggressive Investor)
70
Stocks overvalued when greater than zero
Stocks undervalued when less than zero
60
50
50
40
40
70/30
30
30
50/50
20
20
40/60
10
10
30/70
0
30/70
-10
20/80
10/90
-20
-30
-40
7/26
0
-10
-20
-30
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
-40
* Ratio of S&P 500 index to its fair value (12-month forward consensus expected operating earnings per share
divided by the ten-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after.
Source: Thomson Financial.
- Asset Allocation -
Page 6 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
80
- Valuation Model 1725
1575
1425
1275
1125
975
825
675
Figure 2.
FED’S STOCK VALUATION MODEL (FSVM-1)
(ratio scale)
S&P 500 Price Index
1725
1575
1425
1275
1125
975
825
Fair-Value Price*
675
7/26
525
525
375
375
225
225
75
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
75
* 52-week forward consensus expected S&P 500 operating earnings per share divided by 10-year US Treasury
bond yield. Monthly through March 1994, weekly after.
Source: Thomson Financial.
70
60
Figure 3.
FED’S STOCK VALUATION MODEL (FSVM-1)*
(percent)
70
60
50
50
40
40
30
30
20
20
Overvalued
10
10
0
0
-10
-20
-30
-40
According to the Fed
model, when stock
prices are overpriced,
returns from stocks
are likely to be subpar
over the next 12-24
months.
Better-than-average
returns tend to come
from underpriced
markets.
-10
Undervalued
-20
7/26
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-30
-40
* Ratio of S&P 500 Index to its Fair-Value (52-week forward consensus expected S&P 500 operating earnings
per share divided by the 10-year US Treasury bond yield) minus 100. Monthly through April 1994, weekly
thereafter.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 7
- Valuation Model 18
17
Figure 4.
S&P 500 EARNINGS YIELD & BOND YIELD
18
17
16
This chart appeared in
the Fed’s July 1997
Monetary Policy
Report to the
Congress. It shows a
very close correlation
between the earnings
yield of the stock
market and the bond
yield. Another, more
familiar way to look at
it follows.
16
15
15
Forward Earnings Yield*
14
14
10-Year US Treasury
Bond Yield
13
13
12
12
11
11
10
10
9
9
8
8
7
7/26
7
6
6
5
5
4
4
3
2
3
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
2
* 52-week forward consensus expected S&P 500 operating earnings per share divided by S&P 500 Index.
Monthly through March 1994, weekly after.
Source: Thomson Financial.
The S&P 500 P/E
(using expected
earnings) is highly
correlated with
reciprocal of the bond
yield.
26
25
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
Figure 5.
FORWARD P/E & BOND YIELD
7/26
Ratio Of S&P 500 Price To Expected Earnings*
Fair-Value P/E=Reciprocal Of
Ten-Year U.S. Treasury Bond Yield
Jun
Jun
Jun
Jul
Jul
Jul
Jul
14
21
28
5
12
19
26
Actual
18.1
18.1
17.5
17.1
16.6
15.8
14.9
Fair
20.1
20.7
20.7
20.7
21.2
21.4
22.4
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
Source: Thomson Financial.
Page 8 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
26
25
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
- Earnings 75
70
Figure 6.
S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS
(analysts’ average forecasts)
75
For 2002
For 2001
70
For 2003
65
65
60
60
Forward
Earnings*
7/26
55
55
50
50
45
45
40
Yardeni
I
II
III
IV
I
II
III
IV
I
II
III
Expected forward
earnings is a
time-weighted
average of current and
the coming years’
consensus forecasts.
IV
40
2000
2001
2002
* 52-week forward consensus expected S&P 500 operating earnings per share. Time-weighted average of
current year and next year’s consensus forecasts.
Source: Thomson Financial.
65
Figure 7.
S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED
65
60
60
S&P 500 Earnings Per Share
________________________
55
50
Forward Earnings*
(pushed 52-weeks ahead)
45
Operating Earnings
(4-quarter sum)
7/25
55
50
45
Q1
40
40
35
35
30
30
25
25
20
20
15
15
10
Yardeni
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Bottom-up 52-week
forward expected
earnings tends to be a
good predicator of
actual earnings, with a
few significant misses.
10
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 9
- Earnings 75
70
Figure 8.
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts)
Consensus Forecasts
__________________
12-month forward
Annual estimates
Actual 4Q sum
65
60
75
01
03
99
55
65
00
60
Jul
98
50
70
02
55
50
97
96
45
40
45
40
95
35 91
94
93
92
35
30
30
25
25
20
Analysts always start
out too optimistic
about the prospects
for earnings.
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
Source: Thomson Financial.
35
Figure 9.
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts, ratio scale)
30
82
90
30
Consensus Forecasts
_________________
12-month forward
Annual estimates
Actual 4Q sum
25
35
89
88
85
86
25
87
83
84
20
20
81
80
15
10
15
Yardeni
1978
1979
1980
1981
1982
1983
1984
1985
1986
Source: Thomson Financial.
Page 10 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
1987
1988
1989
1990
1991
10
- Earnings 25
Figure 10.
S&P 500 EARNINGS PER SHARE
25
20
20
7/26
15
15
10
10
7/26
5
5
0
The data on
consensus expected
earnings can be used
to derive consensus
earnings growth
forecasts.
0
-5
-5
Consensus Growth
Forecasts*
_______________
2001/2000
-10
-10
2002/2001
-15
-15
2003/2002
-20
Yardeni
I
II
III
IV
I
II
III
IV
I
II
III
IV
-20
2000
2001
2002
* Based on consensus expected S&P 500 operating earnings per share for years shown.
Source: Thomson Financial.
Figure 11.
S&P 500 OPERATING EARNINGS PER SHARE*
40 (yearly percent change)
45
45
40
35
Actual
35
30
Consensus Forecast
(Proforma)*
30
25
Q4
25
20
20
15
15
10
10
5
5
0
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-30
Earnings growth is
highly cyclical.
-25
Yardeni
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
-30
* S&P 500 composition is constantly changing. Actual data are not adjusted for these changes. Proforma
forecasts are same-company comparisions. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 11
- New Improved Model 2000
Figure 12.
FED’S STOCK VALUATION MODEL (FSVM-2)
2000
1800
1800
This second version of 1600
the Fed’s Stock
Valuation Model builds 1400
on the simple one by
1200
adding variables for
long-term expected
1000
earnings growth and
risk.
800
1600
.25
Actual S&P 500
Fair Value S&P 500*
5-year earnings
growth
weight
_____________
.25
.20
.10
1400
.20
1200
1000
.10
7/26
800
600
600
400
400
200
200
0
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
0
* Fair Value is 12-month forward consensus expected S&P 500 operating earnings per share divided by
difference between Moody’s A-rated corporate bond yield less fraction (as shown above) of 5-year
consensus expected earnings growth.
Source: Thomson Financial
30
Long-term earnings
growth expectations
rose sharply during
1990s. They fell
sharply from
2000-2002.
25
Figure 13.
LONG-TERM CONSENSUS EARNINGS GROWTH*
(annual rate, percent)
30
S&P 500
25
S&P 500 Information Technology
Ex Information Technology
20
20
Jul
15
10
15
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
10
* 5-year forward consensus expected S&P 500 earnings growth. Data from 1995 based on new Global Industry
Classification Standard.
Source: Thomson Financial.
Page 12 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
- New Improved Model 40
Figure 14.
MARKET’S WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH*
(percent)
40
35
35
Weight market gives to long-term earnings growth
________________________________________
value > 13% = more than average weight
value < 13% = less than average weight
30
30
25
25
20
20
Average = 13%
15
15
Jun
10
10
5
5
0
0
-5
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Investors have on
average over time
subtracted 13% of
their long-term
earnings growth
expectations from the
corporate bond yield
to determine earnings
yield.
-5
* Moody’s A-rated corporate bond yield less earnings yield divided by 5-year consensus expected earnings
growth.
* Source: Standard and Poor’s Corporation, Thomson Financial and Moody’s Investors Service.
1.6
Figure 15.
S&P 500 PEG RATIO
1.6
1.5
1.4
1.5
P/E ratio for S&P 500
divided by 5-year consensus
expected earnings growth*
1.4
Jun
1.3
1.2
1.3
Average = 1.2
1.2
1.1
1.1
1.0
1.0
.9
.9
.8
Yardeni
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Historically, S&P 500
sold at P/E of 1.2 times
long-term expected
earnings growth, on
average, with quite a
bit of volatility.
.8
* P/E using 12-month forward consensus S&P 500 expected earnings and prices at mid-month.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 13
- New Improved Model 12
Figure 16.
CORPORATE BOND YIELD
(percent)
12
11
11
10
10
A-Rated
9
9
8
8
7/26
7
6
Corporate bond yield
variable in FSVM-2
captures risk that
earnings will be
weaker than expected.
7
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
6
Source: Moody’s Investors Service.
400
Figure 17.
CORPORATE SPREAD*
(basis points)
400
350
350
300
300
Moody’s A-Rated Corporate Bond Yield
Minus 10-Year US Treasury Bond Yield
7/26
250
250
200
200
150
150
100
100
Average = 131
50
0
50
Yardeni
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
* Monthly through 1994, weekly thereafter.
Source: Board of Governors of the Federal Reserve System and Moody’s Investor Service.
Page 14 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
0
- Global: Expected Earnings* -
Figure 18.
65
UNITED STATES (S&P 500)
325
GERMANY (DAX)
300
60
275
Jul
55
Jul
50
45
250
225
Expected EPS*
(dollars)
Expected EPS
(euros)
200
175
40
150
35
125
30
25
550
525
100
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
CANADA (TSE 300)
FRANCE (CAC 40)
280
260
500
240
475
400
Expected EPS
(euros)
Jul
450
425
75
Expected EPS
(Canadian dollars)
Jul
220
200
375
180
350
160
325
300
140
275
120
250
225
360
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
UNITED KINGDOM (FT 100)
JAPAN (TOPIX)
100
70
340
60
320
300
Expected EPS
(pounds)
Expected EPS
(yen)
50
280
Jul
260
40
240
220
Jul
30
200
180
Yardeni
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 15
- Global: Stock Valuation Figure 19.
80
60
80
UNITED STATES
60
Overvalued
40
40
20
20
0
-20
-40
50
0
Jun
-20
Undervalued
1995
1996
1997
1998
1999
2000
2001
2002
2003
50
CANADA
Overvalued
30
30
10
10
Jun
-10
-30
40
1995
1996
1997
1998
1999
2000
2001
2003
20
Jun
0
-20
Undervalued
1995
1996
1997
1998
1999
2000
2001
2002
2003
60
Overvalued
40
20
20
0
-20
60
Undervalued
1995
1996
1997
1998
0
Jun
1999
2000
2001
2002
-20
2003
40
Overvalued
20
20
0
150
1995
1996
1997
1998
0
Jun
Undervalued
-20
200
-20
1999
2000
2001
2002
2003
150
100
Overvalued
50
50
0
-100
-40
200
JAPAN
100
-50
-40
60
FRANCE
40
-40
-40
80
GERMANY
40
-40
-30
40
Overvalued
-20
60
2002
UNITED KINGDOM
0
80
-10
Undervalued
20
-40
-40
0
Undervalued
Yardeni
1995
1996
1997
-50
Jun
1998
1999
2000
Source: Thomson Financial.
Page 16 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
-100
- Global: United States (S&P 500) -
Figure 20.
160
150
70
STOCK VALUATION MODEL
140
60
Jul
130
50
Industrial Production
(1987=100)
120
40
110
100
30
90
Expected Earnings Per Share*
For S&P 500 (dollars)
80
70
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
20
99
00
01
02
03
04
10
30
30
25
25
Fair-Value P/E
20
Jun
Forward P/E
20
15
15
10
10
5
79
80
81
1825
1475
1125
82
83
84
85
86
87
775
Stock Price Index (S&P 500)
(ratio scale)
425
Fair-Value Price
(ratio scale)
75
70
60
50
40
30
20
10
0
-10
-20
-30
-40
79
80
81
82
83
84
85
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
1825
1475
1125
Jun
775
425
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
Overvalued
Jun
Undervalued
79
80
81
82
83
84
85
5
86
87
88
89
90
91
92
93
Yardeni
94
95
96
97
98
99
00
01
02
03
04
75
70
60
50
40
30
20
10
0
-10
-20
-30
-40
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 17
- Global: Canada (TSE 300) -
Figure 21.
120
115
STOCK VALUATION MODEL
Apr
Expected Earnings Per Share
for TSE 300 (Canadian dollars)
110
Jul
105
100
95
90
Industrial Production
(1997=100)
85
80
75
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
24
550
525
500
475
450
425
400
375
350
325
300
275
250
225
24
22
22
Fair-Value P/E
Forward P/E
20
20
18
18
Jun
16
16
14
14
12
12
10
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
12500
12500
10500
8500
Stock Price Index (TSE 300)
(ratio scale)
6500
Fair-Value
(ratio scale)
10500
8500
Jun
6500
4500
2500
10
4500
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2500
50
50
40
40
30
30
Overvalued
20
20
10
10
0
0
Jun
-10
Undervalued
-20
-30
-10
-20
Yardeni
1993
1994
1995
1996
1997
1998
1999
2000
* Source: Thomson Financial.
Page 18 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
-30
- Global: United Kingdom (FT 100) -
Figure 22.
110
350
STOCK VALUATION MODEL
105
300
100
Industrial Production
(1995=100)
250
95
Jul
85
200
Expected Earnings Per Share
for FT 100 (pounds)
90
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
150
25
25
23
23
21
21
Fair-Value P/E
19
Jun
19
Forward P/E
17
17
15
15
13
13
11
11
9
9
7
1988
1989
7900
7100
6300
5500
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
7900
7100
6300
5500
Stock Price Index (FT 100)
(ratio scale)
4700
Jun
Fair-Value
(ratio scale)
3900
7
4700
3900
3100
3100
2300
2300
1500
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
1500
40
40
30
30
20
20
Overvalued
10
10
Jun
0
0
-10
-10
Undervalued
-20
-30
-20
Yardeni
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-30
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 19
- Global: Germany (DAX) -
Figure 23.
120
325
STOCK VALUATION MODEL
300
275
110
250
Jul
Industrial Production
(1995=100)
225
200
175
100
150
Expected Earnings Per Share
for DAX (Euros)
90
34
32
30
28
26
24
22
20
18
16
14
12
10
8
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
125
100
2002
2003
2004
Fair-Value P/E
Forward P/E
Jun
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
11000
9000
34
32
30
28
26
24
22
20
18
16
14
12
10
8
11000
9000
7000
7000
Stock Price Index (DAX)
(ratio scale)
5000
5000
Jun
Fair-Value
(ratio scale)
3000
1000
75
3000
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
1000
80
80
60
60
Overvalued
40
40
20
20
0
0
Jun
-20
-40
-20
Undervalued
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Thomson Financial.
Page 20 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
2004
-40
- Global: France (CAC 40) -
Figure 24.
120
118
116
114
112
110
108
106
104
102
100
98
275
STOCK VALUATION MODEL
250
225
Jul
200
Industrial Production
(1995=100)
175
150
Expected Earnings Per Share
for CAC 40 (Euros)
1995
1996
1997
1998
1999
2000
125
2001
2002
2003
29
100
29
27
27
25
Fair-Value P/E
25
23
Forward P/E
23
21
21
Jun
19
19
17
17
15
15
13
13
11
1995
1996
1997
1998
1999
2000
2001
2002
2003
7900
7100
6300
5500
7900
7100
6300
5500
Stock Price Index (CAC 40)
(ratio scale)
4700
3900
4700
Jun
3900
Fair-Value
(ratio scale)
3100
3100
2300
1500
11
2300
1995
1996
1997
1998
1999
2000
2001
2002
2003
1500
60
60
40
40
Overvalued
20
20
0
0
Undervalued
-20
-40
Jun
-20
Yardeni
1995
1996
1997
1998
1999
2000
2001
2002
2003
-40
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 21
- Global: Japan (TOPIX) -
Figure 25.
115
60
STOCK VALUATION MODEL
110
Expected Earnings Per Share
for TOPIX (yen)
105
Industrial Production
(1995=100)
50
Jul
40
100
Jun
30
95
90
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
150
20
150
Fair-Value P/E
100
100
Forward P/E
Jun
50
0
50
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0
4500
4500
4000
4000
3500
3500
3000
3000
Stock Price Index (TOPIX)
2500
2500
Fair-Value
2000
2000
1500
1500
Jun
1000
1000
500
0
500
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0
300
300
200
200
Overvalued
100
100
0
0
Undervalued
Jun
-100
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Thomson Financial.
Page 22 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
Yardeni
2003
2004
-100
- Earnings: US vs G5 65
Figure 26.
S&P 500 & G5 FORWARD EARNINGS
300
60
S&P 500 Forward Earnings*
7/26
55
G5 Forward Earnings**
250
Jul
50
45
200
40
35
150
30
25
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
100
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,
France, Germany, Japan and United Kingdom. Source: Thomson Financial.
30
Figure 27.
S&P 500 & G5 FORWARD EARNINGS
(yearly percent change)
Close correlation
between US and G5
profits cycle.
30
20
20
10
10
Jul
0
0
-10
-10
Jul
S&P 500 Forward Earnings*
-20
-20
G5 Forward Earnings**
-30
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-30
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,
France, Germany, Japan and United Kingdom. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 23
- Earnings & Output: US 65
Figure 28.
S&P 500 EARNINGS & INDUSTRIAL PRODUCTION
160
60
150
7/26
Jun
55
50
S&P 500 Forward Earnings*
45
Industrial Production
(1992=100)
140
130
40
120
35
110
30
100
25
90
20
80
15
10
Strong correlation
between US industrial
production and S&P
500 forward earnings.
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
70
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after
Source: Thomson Financial.
30
25
Figure 29.
S&P 500 EARNINGS & PRODUCTION
(yearly percent change)
30
25
20
20
15
15
10
10
5
5
7/26
0
-5
-10
-5
S&P 500 Forward Earnings*
Industrial Production
-15
-20
0
-10
-15
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after
Source: Thomson Financial.
Page 24 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
-20
- Earnings & Prices: US 30
25
Figure 30.
S&P 500 EARNINGS & PRODUCER PRICE INDEX
(yearly percent change)
30
25
20
20
15
15
10
10
5
5
7/26
0
0
Jun
-5
-5
PPI: Intermediate Goods
-10
-10
S&P 500 Forward Earnings*
-15
-20
-15
Yardeni
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
25
Figure 31.
S&P 500 EARNINGS & US IMPORT PRICES
(yearly percent change)
25
20
20
Import Price Index
S&P 500 Forward Earnings*
15
15
10
10
5
5
7/26
0
Jun
-5
0
-5
-10
-10
-15
-15
-20
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Profits cycle is highly
correlated with pricing
cycles especially with
the intermediate
goods PPI and import
prices.
2002
2003
-20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial, US
Department of Labor, Bureau of Labor Statistics.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 25
- Earnings & Output: Europe 120
Figure 32.
FRANCE: EARNINGS & PRODUCTION
275
118
May
116
250
114
Forward Earnings*
112
225
Jul
Industrial Production
(1995=100)
110
108
200
106
104
175
102
100
150
98
96
125
94
92
Industrial production
is key variable driving
profits in France and
UK.
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
100
* 12-month forward consensus expected earnings per share for CAC 40.
Source: Thomson Financial.
110
Figure 33.
UNITED KINGDOM: EARNINGS & PRODUCTION
340
108
320
106
300
104
May
102
280
100
260
98
Forward Earnings*
240
96
Industrial Production
(1995=100)
94
Jul
220
92
200
90
88
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
* 12-month forward consensus expected earnings per share for FT 100.
Source: Thomson Financial.
Page 26 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2000
2001
2002
2003
180
- Earnings & Output: Japan 115
Figure 34.
JAPAN: EARNINGS & PRODUCTION
60
Forward Earnings*
110
50
Industrial Production
(1995=100)
Jul
105
40
100
Jun
30
95
90
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
Japan’s profits cycle
driven by
manufacturing.
* 12-month forward consensus expected operating earnings per share for TOPIX.
Source: Thomson Financial.
100
Figure 35.
JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS
75
Forward Earnings*
50
Tankan Business Conditions:
Major Manufacturers
(diffusion index)
60
50
Jul
25
40
0
30
-25
Q1
-50
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
* 12-month forward consensus expected earnings per share for TOPIX.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 27
RESEARCH
The research analyst(s) or a member of the research analyst’s household does not have a financial interest in any of the tickers mentioned in this report.
The research analyst or a member of the team does not have a material conflict of interest relative to any stock mentioned in this report
The research analyst has not received compensation that is based upon (among other factors) the firm’s investment banking revenues as it related to any stock mentioned in this report
The research analyst, a member of the team, or a member of the household do not serve as an officer, director, or advisory board member of any stock mentioned in this report
Prudential Securities has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm
When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of 15% or more over the next 12 to 18 months. For higher
risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18
months.
When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline 15% or more over the next 12 to 18 months. For lower risk
stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18
months.
A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or
because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell.
Rating distribution
07/15/02
Buy
Hold
Sell
Excludes Closed End Funds
Firm
40.00%
56.00%
3.00%
IBG Clients
4.00%
5.00%
1.00%
Any OTC-traded securities or non-U.S. companies mentioned in this report may not be cleared for sale in all states.
50.00%
50.00%
0.00%
02-XXXX
Securities products and services are offered through Prudential Securities Incorporated, a Prudential company.
©Prudential Securities Incorporated, 2002, all rights reserved. One Seaport Plaza, New York, NY 10292
Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ, and its affiliates.
Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such
information has not been verified by us, and we do not make any representations as to its accuracy or completeness. Any statements nonfactual in nature constitute only current opinions,
which are subject to change. Prudential Securities Incorporated (or one of its affiliates or subsidiaries) or their officers, directors, analysts, employees, agents, independent contractors, or
consultants may have positions in securities or commodities referred to herein and may, as principal or agent, buy and sell such securities or commodities. An employee, analyst, officer, agent,
independent contractor, a director, or a consultant of Prudential Securities Incorporated, its affiliates, or its subsidiaries may serve as a director for companies mentioned in this report. Neither
the information nor any opinion expressed shall constitute an offer to sell or a solicitation of an offer to buy any securities or commodities mentioned herein. There may be instances when
fundamental, technical, and quantitative opinions may not be in concert. This firm (or one of its affiliates or subsidiaries) may from time to time perform investment banking or other services for,
or solicit investment banking or other business from, any company mentioned in this report.
There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange rate
fluctuations, and limited availability of information on international securities. Prudential Securities Incorporated, its affiliates, and its subsidiaries make no representation that the companies
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Sales of securities covered by this report may be made only in those jurisdictions where the security is qualified for sale. The contents of this publication have been approved for distribution by
Prudential-Bache International Limited, which is regulated by The Securities and Futures Authority Limited. We recommend that you obtain the advice of your Financial Advisor regarding this or
other investments.
Additional information on the securities discussed herein is available upon request.
July 30, 2002
Dr. Edward Yardeni
(212) 778-2646
ed_yardeni@prusec.com
Amalia F. Quintana
(212) 778-3201
mali_quintana@prusec.com
Asset Valuation & Allocation
Models
- Introduction I. Fed’s Stock Valuation Model
How can we judge whether stock prices are too high, too low, or just right? The purpose
of this weekly report is to track a stock valuation model that attempts to answer this
question. While the model is very simple, it has been quite accurate and can also be used
as a stocks-versus-bonds asset allocation tool. I started to study the model in 1997, after
reading that the folks at the Federal Reserve have been using it. If it is good enough for
them, it’s good enough for me. I dubbed it the Fed’s Stock Valuation Model (FSVM),
though no one at the Fed ever officially endorsed it.
On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board,
famously worried out loud for the first time about “irrational exuberance” in the stock
market. He didn’t actually say that stock prices were too high. Rather he asked the
question: “But how do we know when irrational exuberance has unduly escalated asset
values, which then become subject to unexpected and prolonged contractions….”1 He did
it again on February 26, 1997.2 2 He probably instructed his staff to devise a stock market
valuation model to help him evaluate the extent of the market’s exuberance. Apparently,
they did so and it was made public, though buried, in the Fed’s Monetary Policy Report
to the Congress, which accompanied Mr. Greenspan’s Humphrey-Hawkins testimony on
July 22, 1997. 3
The Fed model was summed up in one paragraph and one chart on page 24 of the 25page document (see following table). The chart shows a strong correlation between the
S&P 500 forward earnings yield (FEY)—i.e., the ratio of expected operating earnings (E)
to the price index for the S&P 500 companies (P), using 12- month-ahead consensus
earnings estimates compiled by Thomson Financial First Call.—and the 10-year Treasury
bond yield (TBY). The average spread between the forward earnings yield and the
Treasury yield (i.e., FEY-TBY) is 29 basis points since 1979. This near-zero average
implies that the market is fairly valued when the two are identical:
1) FEY = TBY
Of course, in the investment community, we tend to follow the price-to-earnings ratio
more than the earnings yield. The ratio of the S&P 500 price index to expected earnings
(P/E) is highly correlated with the reciprocal of the 10-year bond yield, and on average
the two have been nearly identical. In other words, the “fair value” price for the S&P 500
(FVP) is equal to expected earnings divided by the bond yield in the Fed’s valuation
model:
2) FVP = E/TBY
1
http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm
“We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the
current environment to keep this question on the table.”
http://www.federalreserve.gov/boarddocs/hh/1997/february/testimony.htm
3
http://www.federalreserve.gov/boarddocs/hh/1997/july/ReportSection2.htm
2
Page 2 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
Excerpt from Fed’s July 1997 Monetary Policy Report:
The run-up in stock prices in the spring was bolstered by unexpectedly strong
corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to
consensus estimates of earnings over the coming twelve months has risen
further from levels that were already unusually high. Changes in this ratio have
often been inversely related to changes in long-term Treasury yields, but this
year’s stock price gains were not matched by a significant net decline in interest
rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of
twelve-month-ahead earnings to prices by the largest amount since 1991, when
earnings were depressed by the economic slowdown. One important factor
behind the increase in stock prices this year appears to be a further rise in
analysts’ reported expectations of earnings growth over the next three to five
years. The average of these expectations has risen fairly steadily since early
1995 and currently stands at a level not seen since the steep recession of the
early 1980s, when earnings were expected to bounce back from levels that were
quite low.
The ratio of the actual S&P 500 price index to the fair value price shows the degree of
overvaluation or undervaluation. History shows that markets can stay overvalued and
become even more overvalued for a while. But eventually, overvaluation is corrected in
three ways: 1) falling interest rates, 2) higher earnings expectations, and of course, 3)
falling stock prices—the old fashioned way to decrease values. Undervaluation can be
corrected by rising yields, lower earnings expectations, or higher stock prices.
The Fed’s Stock Valuation Model worked quite well in the past. It identified when stock
prices were excessively overvalued or undervalued, and likely to fall or rise:
1) The market was extremely undervalued from 1979 through 1982, setting the stage
for a powerful rally that lasted through the summer of 1987.
2) Stock prices crashed after the market rose to a record 34% overvaluation peak during
September 1987.
3) Then the market was undervalued in the late 1980s, and stock prices rose.
4) In the early 1990s, it was moderately overvalued and stock values advanced at a
lackluster pace.
5) Stock prices were mostly undervalued during the mid-1990s, and a great bull market
started in late 1994.
6) Ironically, the market was actually fairly valued during December 1996 when the
Fed Chairman worried out loud about irrational exuberance.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 3
7) During both the summers of 1997 and 1998, overvaluation conditions were corrected
by a sharp drop in prices.
8) Then a two- month undervaluation condition during September and October 1998
was quickly reversed as stock prices soared to a remarkable record 70%
overvaluation reading during 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
II. New Improved Model
The FSVM is missing a variable reflecting that the forward earnings yield is riskier than
the government bond yield. How should we measure risk in the model? An obvious
choice is to use the spread between corporate bond yields and Treasury bond yields. This
spread measures the market’s assessment of the risk that some corporations might be
forced to default on their bonds. Of course, such events are very unusual, especially for
companies included in the S&P 500. However, the spread is only likely to widen during
periods of economic distress, when bond investors tend to worry that profits won’t be
sufficient to meet the debt-servicing obligations of some companies. Most companies
won’t have this problem, but their earnings would most likely be depressed during such
periods. The FSVM is also missing a variable for long-term earnings growth. My New
Improved Model includes these variables as follows:
3) FEY = CBY – b · · LTEG
where CBY is Moody’s A-rated corporate bond yield. LTEG is long-term expected
earnings growth, which is measured using consensus five- year earnings growth
projections. I/B/E/S International compiles these monthly. The “b” coefficient is the
weight that the market gives to long-term earnings projections. It can be derived as [FEY-CBY]/LTEG. Since the start of the data in 1985, this “earnings growth coefficient”
averaged 0.1.
Equation 3 can be rearranged to produce the following:
4) FVP = E ¸ ¸ [CBY – b · · LTEG]
FVP is the fair value price of the S&P 500 index. Exhibit 10 shows three fair value price
series using the actual data for E, CBY, and LTEG with b = 0.1, b = 0.2, and b = 0.25.
The market was fairly valued during 1999 and the first half of 2000 based on the
consensus forecast that earnings could grow more than 16% per year over the next five
years and that this variable should be weighted by 0.25, or two and a half times more than
the average historical weight.
III. Back To Basics
With the benefit of hindsight, it seems that these assumptions were too optimistic. But,
Page 4 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
this is exactly the added value of the New Improved FSVM. It can be used to make
explicit the implicit assumptions in the stock market about the weight given to long-term
earnings growth. The simple version has worked so well historically because the longterm growth component has been offset on average by the risk variable in the corporate
bond market.
IV. Stocks Versus Bonds
The FSVM is a very simple stock valuation model. It should be used along with other
stock valuation tools, including the New Improved version of the model. Of course, there
are numerous other more sophisticated and complex models. The Fed model is not a
market-timing tool. As noted above, an overvalued (undervalued) market can become
even more overvalued (undervalued). However, the Fed model does have a good track
record of showing whether stocks are cheap or expensive. Investors are likely to earn
below (above) average returns over the next 12-24 months when the market is overvalued
(undervalued).
The next logical step is to convert the FSVM into a simple asset allocation model
(Exhibit 1). I’ve done so by subjectively associating the “right” stock/bond asset mixes
with the degree of over/under valuation as shown in the table below. For example,
whenever stocks are 10% to 20% overvalued, I would recommend that a moderately
aggressive investor should have a mix of 60% in stocks and 40% in bonds in their
portfolio.
Bonds/Stocks Asset Allocation Model
More than 30% overvalued
20% to 30% overvalued
10% to 20% overvalued
10% undervalued to 10% overvalued
10% to 15% undervalued
More than 15% undervalued
70% bonds, 30% stocks
50% bonds, 50% stocks
40% bonds, 60% stocks
30% bonds, 70% stocks
20% bonds, 80% stocks
10% bonds, 90% stocks
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 5
70
60
80
ED YARDENI’S ASSET ALLOCATION MODEL: BONDS/STOCKS*
(for Moderately Aggressive Investor)
70
Stocks overvalued when greater than zero
Stocks undervalued when less than zero
60
50
50
40
40
70/30
30
30
50/50
20
20
40/60
10
10
30/70
0
30/70
-10
20/80
10/90
-20
-30
-40
7/26
0
-10
-20
-30
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
-40
* Ratio of S&P 500 index to its fair value (12-month forward consensus expected operating earnings per share
divided by the ten-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after.
Source: Thomson Financial.
- Asset Allocation -
Page 6 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
80
- Valuation Model 1725
1575
1425
1275
1125
975
825
675
Figure 2.
FED’S STOCK VALUATION MODEL (FSVM-1)
(ratio scale)
S&P 500 Price Index
1725
1575
1425
1275
1125
975
825
Fair-Value Price*
675
7/26
525
525
375
375
225
225
75
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
75
* 52-week forward consensus expected S&P 500 operating earnings per share divided by 10-year US Treasury
bond yield. Monthly through March 1994, weekly after.
Source: Thomson Financial.
70
60
Figure 3.
FED’S STOCK VALUATION MODEL (FSVM-1)*
(percent)
70
60
50
50
40
40
30
30
20
20
Overvalued
10
10
0
0
-10
-20
-30
-40
According to the Fed
model, when stock
prices are overpriced,
returns from stocks
are likely to be subpar
over the next 12-24
months.
Better-than-average
returns tend to come
from underpriced
markets.
-10
Undervalued
-20
7/26
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-30
-40
* Ratio of S&P 500 Index to its Fair-Value (52-week forward consensus expected S&P 500 operating earnings
per share divided by the 10-year US Treasury bond yield) minus 100. Monthly through April 1994, weekly
thereafter.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 7
- Valuation Model 18
17
Figure 4.
S&P 500 EARNINGS YIELD & BOND YIELD
18
17
16
This chart appeared in
the Fed’s July 1997
Monetary Policy
Report to the
Congress. It shows a
very close correlation
between the earnings
yield of the stock
market and the bond
yield. Another, more
familiar way to look at
it follows.
16
15
15
Forward Earnings Yield*
14
14
10-Year US Treasury
Bond Yield
13
13
12
12
11
11
10
10
9
9
8
8
7
7/26
7
6
6
5
5
4
4
3
2
3
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
2
* 52-week forward consensus expected S&P 500 operating earnings per share divided by S&P 500 Index.
Monthly through March 1994, weekly after.
Source: Thomson Financial.
The S&P 500 P/E
(using expected
earnings) is highly
correlated with
reciprocal of the bond
yield.
26
25
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
Figure 5.
FORWARD P/E & BOND YIELD
7/26
Ratio Of S&P 500 Price To Expected Earnings*
Fair-Value P/E=Reciprocal Of
Ten-Year U.S. Treasury Bond Yield
Jun
Jun
Jun
Jul
Jul
Jul
Jul
14
21
28
5
12
19
26
Actual
18.1
18.1
17.5
17.1
16.6
15.8
14.9
Fair
20.1
20.7
20.7
20.7
21.2
21.4
22.4
Yardeni
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
Source: Thomson Financial.
Page 8 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
26
25
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
- Earnings 75
70
Figure 6.
S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS
(analysts’ average forecasts)
75
For 2002
For 2001
70
For 2003
65
65
60
60
Forward
Earnings*
7/26
55
55
50
50
45
45
40
Yardeni
I
II
III
IV
I
II
III
IV
I
II
III
Expected forward
earnings is a
time-weighted
average of current and
the coming years’
consensus forecasts.
IV
40
2000
2001
2002
* 52-week forward consensus expected S&P 500 operating earnings per share. Time-weighted average of
current year and next year’s consensus forecasts.
Source: Thomson Financial.
65
Figure 7.
S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED
65
60
60
S&P 500 Earnings Per Share
________________________
55
50
Forward Earnings*
(pushed 52-weeks ahead)
45
Operating Earnings
(4-quarter sum)
7/25
55
50
45
Q1
40
40
35
35
30
30
25
25
20
20
15
15
10
Yardeni
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Bottom-up 52-week
forward expected
earnings tends to be a
good predicator of
actual earnings, with a
few significant misses.
10
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 9
- Earnings 75
70
Figure 8.
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts)
Consensus Forecasts
__________________
12-month forward
Annual estimates
Actual 4Q sum
65
60
75
01
03
99
55
65
00
60
Jul
98
50
70
02
55
50
97
96
45
40
45
40
95
35 91
94
93
92
35
30
30
25
25
20
Analysts always start
out too optimistic
about the prospects
for earnings.
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
Source: Thomson Financial.
35
Figure 9.
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts, ratio scale)
30
82
90
30
Consensus Forecasts
_________________
12-month forward
Annual estimates
Actual 4Q sum
25
35
89
88
85
86
25
87
83
84
20
20
81
80
15
10
15
Yardeni
1978
1979
1980
1981
1982
1983
1984
1985
1986
Source: Thomson Financial.
Page 10 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
1987
1988
1989
1990
1991
10
- Earnings 25
Figure 10.
S&P 500 EARNINGS PER SHARE
25
20
20
7/26
15
15
10
10
7/26
5
5
0
The data on
consensus expected
earnings can be used
to derive consensus
earnings growth
forecasts.
0
-5
-5
Consensus Growth
Forecasts*
_______________
2001/2000
-10
-10
2002/2001
-15
-15
2003/2002
-20
Yardeni
I
II
III
IV
I
II
III
IV
I
II
III
IV
-20
2000
2001
2002
* Based on consensus expected S&P 500 operating earnings per share for years shown.
Source: Thomson Financial.
Figure 11.
S&P 500 OPERATING EARNINGS PER SHARE*
40 (yearly percent change)
45
45
40
35
Actual
35
30
Consensus Forecast
(Proforma)*
30
25
Q4
25
20
20
15
15
10
10
5
5
0
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-30
Earnings growth is
highly cyclical.
-25
Yardeni
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
-30
* S&P 500 composition is constantly changing. Actual data are not adjusted for these changes. Proforma
forecasts are same-company comparisions. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 11
- New Improved Model 2000
Figure 12.
FED’S STOCK VALUATION MODEL (FSVM-2)
2000
1800
1800
This second version of 1600
the Fed’s Stock
Valuation Model builds 1400
on the simple one by
1200
adding variables for
long-term expected
1000
earnings growth and
risk.
800
1600
.25
Actual S&P 500
Fair Value S&P 500*
5-year earnings
growth
weight
_____________
.25
.20
.10
1400
.20
1200
1000
.10
7/26
800
600
600
400
400
200
200
0
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
0
* Fair Value is 12-month forward consensus expected S&P 500 operating earnings per share divided by
difference between Moody’s A-rated corporate bond yield less fraction (as shown above) of 5-year
consensus expected earnings growth.
Source: Thomson Financial
30
Long-term earnings
growth expectations
rose sharply during
1990s. They fell
sharply from
2000-2002.
25
Figure 13.
LONG-TERM CONSENSUS EARNINGS GROWTH*
(annual rate, percent)
30
S&P 500
25
S&P 500 Information Technology
Ex Information Technology
20
20
Jul
15
10
15
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
10
* 5-year forward consensus expected S&P 500 earnings growth. Data from 1995 based on new Global Industry
Classification Standard.
Source: Thomson Financial.
Page 12 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
- New Improved Model 40
Figure 14.
MARKET’S WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH*
(percent)
40
35
35
Weight market gives to long-term earnings growth
________________________________________
value > 13% = more than average weight
value < 13% = less than average weight
30
30
25
25
20
20
Average = 13%
15
15
Jun
10
10
5
5
0
0
-5
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Investors have on
average over time
subtracted 13% of
their long-term
earnings growth
expectations from the
corporate bond yield
to determine earnings
yield.
-5
* Moody’s A-rated corporate bond yield less earnings yield divided by 5-year consensus expected earnings
growth.
* Source: Standard and Poor’s Corporation, Thomson Financial and Moody’s Investors Service.
1.6
Figure 15.
S&P 500 PEG RATIO
1.6
1.5
1.4
1.5
P/E ratio for S&P 500
divided by 5-year consensus
expected earnings growth*
1.4
Jun
1.3
1.2
1.3
Average = 1.2
1.2
1.1
1.1
1.0
1.0
.9
.9
.8
Yardeni
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Historically, S&P 500
sold at P/E of 1.2 times
long-term expected
earnings growth, on
average, with quite a
bit of volatility.
.8
* P/E using 12-month forward consensus S&P 500 expected earnings and prices at mid-month.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 13
- New Improved Model 12
Figure 16.
CORPORATE BOND YIELD
(percent)
12
11
11
10
10
A-Rated
9
9
8
8
7/26
7
6
Corporate bond yield
variable in FSVM-2
captures risk that
earnings will be
weaker than expected.
7
Yardeni
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
6
Source: Moody’s Investors Service.
400
Figure 17.
CORPORATE SPREAD*
(basis points)
400
350
350
300
300
Moody’s A-Rated Corporate Bond Yield
Minus 10-Year US Treasury Bond Yield
7/26
250
250
200
200
150
150
100
100
Average = 131
50
0
50
Yardeni
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
* Monthly through 1994, weekly thereafter.
Source: Board of Governors of the Federal Reserve System and Moody’s Investor Service.
Page 14 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
0
- Global: Expected Earnings* -
Figure 18.
65
UNITED STATES (S&P 500)
325
GERMANY (DAX)
300
60
275
Jul
55
Jul
50
45
250
225
Expected EPS*
(dollars)
Expected EPS
(euros)
200
175
40
150
35
125
30
25
550
525
100
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
CANADA (TSE 300)
FRANCE (CAC 40)
280
260
500
240
475
400
Expected EPS
(euros)
Jul
450
425
75
Expected EPS
(Canadian dollars)
Jul
220
200
375
180
350
160
325
300
140
275
120
250
225
360
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
UNITED KINGDOM (FT 100)
JAPAN (TOPIX)
100
70
340
60
320
300
Expected EPS
(pounds)
Expected EPS
(yen)
50
280
Jul
260
40
240
220
Jul
30
200
180
Yardeni
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 15
- Global: Stock Valuation Figure 19.
80
60
80
UNITED STATES
60
Overvalued
40
40
20
20
0
-20
-40
50
0
Jun
-20
Undervalued
1995
1996
1997
1998
1999
2000
2001
2002
2003
50
CANADA
Overvalued
30
30
10
10
Jun
-10
-30
40
1995
1996
1997
1998
1999
2000
2001
2003
20
Jun
0
-20
Undervalued
1995
1996
1997
1998
1999
2000
2001
2002
2003
60
Overvalued
40
20
20
0
-20
60
Undervalued
1995
1996
1997
1998
0
Jun
1999
2000
2001
2002
-20
2003
40
Overvalued
20
20
0
150
1995
1996
1997
1998
0
Jun
Undervalued
-20
200
-20
1999
2000
2001
2002
2003
150
100
Overvalued
50
50
0
-100
-40
200
JAPAN
100
-50
-40
60
FRANCE
40
-40
-40
80
GERMANY
40
-40
-30
40
Overvalued
-20
60
2002
UNITED KINGDOM
0
80
-10
Undervalued
20
-40
-40
0
Undervalued
Yardeni
1995
1996
1997
-50
Jun
1998
1999
2000
Source: Thomson Financial.
Page 16 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
-100
- Global: United States (S&P 500) -
Figure 20.
160
150
70
STOCK VALUATION MODEL
140
60
Jul
130
50
Industrial Production
(1987=100)
120
40
110
100
30
90
Expected Earnings Per Share*
For S&P 500 (dollars)
80
70
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
20
99
00
01
02
03
04
10
30
30
25
25
Fair-Value P/E
20
Jun
Forward P/E
20
15
15
10
10
5
79
80
81
1825
1475
1125
82
83
84
85
86
87
775
Stock Price Index (S&P 500)
(ratio scale)
425
Fair-Value Price
(ratio scale)
75
70
60
50
40
30
20
10
0
-10
-20
-30
-40
79
80
81
82
83
84
85
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
1825
1475
1125
Jun
775
425
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
Overvalued
Jun
Undervalued
79
80
81
82
83
84
85
5
86
87
88
89
90
91
92
93
Yardeni
94
95
96
97
98
99
00
01
02
03
04
75
70
60
50
40
30
20
10
0
-10
-20
-30
-40
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 17
- Global: Canada (TSE 300) -
Figure 21.
120
115
STOCK VALUATION MODEL
Apr
Expected Earnings Per Share
for TSE 300 (Canadian dollars)
110
Jul
105
100
95
90
Industrial Production
(1997=100)
85
80
75
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
24
550
525
500
475
450
425
400
375
350
325
300
275
250
225
24
22
22
Fair-Value P/E
Forward P/E
20
20
18
18
Jun
16
16
14
14
12
12
10
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
12500
12500
10500
8500
Stock Price Index (TSE 300)
(ratio scale)
6500
Fair-Value
(ratio scale)
10500
8500
Jun
6500
4500
2500
10
4500
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2500
50
50
40
40
30
30
Overvalued
20
20
10
10
0
0
Jun
-10
Undervalued
-20
-30
-10
-20
Yardeni
1993
1994
1995
1996
1997
1998
1999
2000
* Source: Thomson Financial.
Page 18 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
-30
- Global: United Kingdom (FT 100) -
Figure 22.
110
350
STOCK VALUATION MODEL
105
300
100
Industrial Production
(1995=100)
250
95
Jul
85
200
Expected Earnings Per Share
for FT 100 (pounds)
90
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
150
25
25
23
23
21
21
Fair-Value P/E
19
Jun
19
Forward P/E
17
17
15
15
13
13
11
11
9
9
7
1988
1989
7900
7100
6300
5500
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
7900
7100
6300
5500
Stock Price Index (FT 100)
(ratio scale)
4700
Jun
Fair-Value
(ratio scale)
3900
7
4700
3900
3100
3100
2300
2300
1500
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
1500
40
40
30
30
20
20
Overvalued
10
10
Jun
0
0
-10
-10
Undervalued
-20
-30
-20
Yardeni
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-30
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 19
- Global: Germany (DAX) -
Figure 23.
120
325
STOCK VALUATION MODEL
300
275
110
250
Jul
Industrial Production
(1995=100)
225
200
175
100
150
Expected Earnings Per Share
for DAX (Euros)
90
34
32
30
28
26
24
22
20
18
16
14
12
10
8
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
125
100
2002
2003
2004
Fair-Value P/E
Forward P/E
Jun
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
11000
9000
34
32
30
28
26
24
22
20
18
16
14
12
10
8
11000
9000
7000
7000
Stock Price Index (DAX)
(ratio scale)
5000
5000
Jun
Fair-Value
(ratio scale)
3000
1000
75
3000
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
1000
80
80
60
60
Overvalued
40
40
20
20
0
0
Jun
-20
-40
-20
Undervalued
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Thomson Financial.
Page 20 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
2003
2004
-40
- Global: France (CAC 40) -
Figure 24.
120
118
116
114
112
110
108
106
104
102
100
98
275
STOCK VALUATION MODEL
250
225
Jul
200
Industrial Production
(1995=100)
175
150
Expected Earnings Per Share
for CAC 40 (Euros)
1995
1996
1997
1998
1999
2000
125
2001
2002
2003
29
100
29
27
27
25
Fair-Value P/E
25
23
Forward P/E
23
21
21
Jun
19
19
17
17
15
15
13
13
11
1995
1996
1997
1998
1999
2000
2001
2002
2003
7900
7100
6300
5500
7900
7100
6300
5500
Stock Price Index (CAC 40)
(ratio scale)
4700
3900
4700
Jun
3900
Fair-Value
(ratio scale)
3100
3100
2300
1500
11
2300
1995
1996
1997
1998
1999
2000
2001
2002
2003
1500
60
60
40
40
Overvalued
20
20
0
0
Undervalued
-20
-40
Jun
-20
Yardeni
1995
1996
1997
1998
1999
2000
2001
2002
2003
-40
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 21
- Global: Japan (TOPIX) -
Figure 25.
115
60
STOCK VALUATION MODEL
110
Expected Earnings Per Share
for TOPIX (yen)
105
Industrial Production
(1995=100)
50
Jul
40
100
Jun
30
95
90
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
150
20
150
Fair-Value P/E
100
100
Forward P/E
Jun
50
0
50
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0
4500
4500
4000
4000
3500
3500
3000
3000
Stock Price Index (TOPIX)
2500
2500
Fair-Value
2000
2000
1500
1500
Jun
1000
1000
500
0
500
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0
300
300
200
200
Overvalued
100
100
0
0
Undervalued
Jun
-100
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Thomson Financial.
Page 22 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2001
2002
Yardeni
2003
2004
-100
- Earnings: US vs G5 65
Figure 26.
S&P 500 & G5 FORWARD EARNINGS
300
60
S&P 500 Forward Earnings*
7/26
55
G5 Forward Earnings**
250
Jul
50
45
200
40
35
150
30
25
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
100
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after.
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,
France, Germany, Japan and United Kingdom. Source: Thomson Financial.
30
Figure 27.
S&P 500 & G5 FORWARD EARNINGS
(yearly percent change)
Close correlation
between US and G5
profits cycle.
30
20
20
10
10
Jul
0
0
-10
-10
Jul
S&P 500 Forward Earnings*
-20
-20
G5 Forward Earnings**
-30
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-30
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,
France, Germany, Japan and United Kingdom. Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 23
- Earnings & Output: US 65
Figure 28.
S&P 500 EARNINGS & INDUSTRIAL PRODUCTION
160
60
150
7/26
Jun
55
50
S&P 500 Forward Earnings*
45
Industrial Production
(1992=100)
140
130
40
120
35
110
30
100
25
90
20
80
15
10
Strong correlation
between US industrial
production and S&P
500 forward earnings.
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
70
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after
Source: Thomson Financial.
30
25
Figure 29.
S&P 500 EARNINGS & PRODUCTION
(yearly percent change)
30
25
20
20
15
15
10
10
5
5
7/26
0
-5
-10
-5
S&P 500 Forward Earnings*
Industrial Production
-15
-20
0
-10
-15
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
weekly after
Source: Thomson Financial.
Page 24 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
-20
- Earnings & Prices: US 30
25
Figure 30.
S&P 500 EARNINGS & PRODUCER PRICE INDEX
(yearly percent change)
30
25
20
20
15
15
10
10
5
5
7/26
0
0
Jun
-5
-5
PPI: Intermediate Goods
-10
-10
S&P 500 Forward Earnings*
-15
-20
-15
Yardeni
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
25
Figure 31.
S&P 500 EARNINGS & US IMPORT PRICES
(yearly percent change)
25
20
20
Import Price Index
S&P 500 Forward Earnings*
15
15
10
10
5
5
7/26
0
Jun
-5
0
-5
-10
-10
-15
-15
-20
Yardeni
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Profits cycle is highly
correlated with pricing
cycles especially with
the intermediate
goods PPI and import
prices.
2002
2003
-20
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial, US
Department of Labor, Bureau of Labor Statistics.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 25
- Earnings & Output: Europe 120
Figure 32.
FRANCE: EARNINGS & PRODUCTION
275
118
May
116
250
114
Forward Earnings*
112
225
Jul
Industrial Production
(1995=100)
110
108
200
106
104
175
102
100
150
98
96
125
94
92
Industrial production
is key variable driving
profits in France and
UK.
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
100
* 12-month forward consensus expected earnings per share for CAC 40.
Source: Thomson Financial.
110
Figure 33.
UNITED KINGDOM: EARNINGS & PRODUCTION
340
108
320
106
300
104
May
102
280
100
260
98
Forward Earnings*
240
96
Industrial Production
(1995=100)
94
Jul
220
92
200
90
88
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
* 12-month forward consensus expected earnings per share for FT 100.
Source: Thomson Financial.
Page 26 / July 30, 2002 / Prudential Securities Asset Valuation & Allocation Models
2000
2001
2002
2003
180
- Earnings & Output: Japan 115
Figure 34.
JAPAN: EARNINGS & PRODUCTION
60
Forward Earnings*
110
50
Industrial Production
(1995=100)
Jul
105
40
100
Jun
30
95
90
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
Japan’s profits cycle
driven by
manufacturing.
* 12-month forward consensus expected operating earnings per share for TOPIX.
Source: Thomson Financial.
100
Figure 35.
JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS
75
Forward Earnings*
50
Tankan Business Conditions:
Major Manufacturers
(diffusion index)
60
50
Jul
25
40
0
30
-25
Q1
-50
Yardeni
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
* 12-month forward consensus expected earnings per share for TOPIX.
Source: Thomson Financial.
Prudential Securities Asset Valuation & Allocation Models / July 30, 2002 / Page 27
RESEARCH
The research analyst(s) or a member of the research analyst’s household does not have a financial interest in any of the tickers mentioned in this report.
The research analyst or a member of the team does not have a material conflict of interest relative to any stock mentioned in this report
The research analyst has not received compensation that is based upon (among other factors) the firm’s investment banking revenues as it related to any stock mentioned in this report
The research analyst, a member of the team, or a member of the household do not serve as an officer, director, or advisory board member of any stock mentioned in this report
Prudential Securities has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm
When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of 15% or more over the next 12 to 18 months. For higher
risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18
months.
When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline 15% or more over the next 12 to 18 months. For lower risk
stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18
months.
A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or
because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell.
Rating distribution
07/15/02
Buy
Hold
Sell
Excludes Closed End Funds
Firm
40.00%
56.00%
3.00%
IBG Clients
4.00%
5.00%
1.00%
Any OTC-traded securities or non-U.S. companies mentioned in this report may not be cleared for sale in all states.
50.00%
50.00%
0.00%
02-XXXX
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Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such
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