Enrich Your Future 09: The Fed Model and the Money Illusion

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 09: The Fed Model and the Money Illusion.LEARNING: Just because there is a correlation doesn’t mean that there’s causation. “Just because there is a correlation doesn’t mean that there’s causation. The mere existence of a correlation doesn’t necessarily give it predictive value.”Larry Swedroe In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 09: The Fed Model and the Money Illusion.Chapter 09: The Fed Model and the Money IllusionIn this chapter, Larry illustrates why the Fed Model should not be used to determine whether the market is at fair value and that the E/P ratio is a much better predictor of future real returns.The FED modelThe stock and bond markets are filled with wrongheaded data mining. David Leinweber of First Quadrant famously illustrated this point with what he called “stupid data miner tricks.”Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh. His example perfectly illustrates that a correlation’s mere existence doesn’t necessarily give it predictive value. Some logical reason for the correlation is required for it to have credibility. Without a logical reason, the correlation is just a mere illusion.According to Larry, the “money illusion” has the potential to create investment mistakes. It relates to one of the most popular indicators used by investors to determine whether the market is under or overvalued—what is known as “the Fed Model.”The Federal Reserve was using the Fed model to determine if the market was fairly valued and how attractive stocks were priced relative to bonds. Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the earnings-price, or E/P, ratio (the inverse of the popular price-to-earnings, or P/E, ratio).Larry points out two major problems with the Fed Model. The first relates to how the model is used by many investors. Edward Yardeni, at the time a market strategist for Morgan, Grenfell & Co. speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments.The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds.Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the...