Asset Valuation Allocation Models

R e s e a r c h Asset Valuation & Allocation
July 30, 2002

Models
Dr. Edward Yardeni

(212) 778-2646
ed_yardeni@prusec.com
Amalia F. Quintana
(212) 778-3201
mali_quintana@prusec.com
- 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 25-
page 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
2
“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
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,
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 long-
term 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 70% bonds, 30% stocks
20% to 30% overvalued 50% bonds, 50% stocks
10% to 20% overvalued 40% bonds, 60% stocks
10% undervalued to 10% overvalued 30% bonds, 70% stocks
10% to 15% undervalued 20% bonds, 80% stocks
More than 15% undervalued 10% bonds, 90% stocks
80 80
ED YARDENI’S ASSET ALLOCATION MODEL: BONDS/STOCKS*
70 (for Moderately Aggressive Investor) 70
Stocks overvalued when greater than zero
60 60
Stocks undervalued when less than zero
50 50
40 40
- Asset Allocation -
70/30
30 30
50/50
20 20
40/60
10 10
30/70
0 0
30/70
-10 -10
20/80
-20 10/90 -20
-30 -30
7/26
Yardeni
-40 -40
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
* 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.
- Valuation Model -
Figure 2.
1725 1725
1575 FED’S STOCK VALUATION MODEL (FSVM-1) 1575
1425 (ratio scale) 1425
1275 7/26 1275
1125 1125
975 975
825 S&P 500 Price Index 825
675 Fair-Value Price* 675
525 525
375 375
225 225
According to the Fed

model, when stock
Yardeni
75 75 prices are overpriced,
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
returns from stocks
* 52-week forward consensus expected S&P 500 operating earnings per share divided by 10-year US Treasury are likely to be subpar
bond yield. Monthly through March 1994, weekly after.
Source: Thomson Financial. over the next 12-24
months.
Better-than-average
Figure 3.
70 70 returns tend to come
FED’S STOCK VALUATION MODEL (FSVM-1)* from underpriced
(percent)
60 60 markets.
50 50
40 40
30 30
20 20
Overvalued
10 10
0 0
-10 -10
-20 Undervalued -20
-30 -30
7/26
Yardeni
-40 -40
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
* 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.
- Valuation Model -
Figure 4.
18 18
S&P 500 EARNINGS YIELD & BOND YIELD
17 17
16 16
15 15
This chart appeared in Forward Earnings Yield*
the Fed’s July 1997 14 14
10-Year US Treasury
Monetary Policy 13 Bond Yield 13
Report to the 12 12
Congress. It shows a 11 11
very close correlation 10 10
between the earnings
9 9
yield of the stock
market and the bond 8 8
yield. Another, more 7
7/26 7
familiar way to look at 6 6
it follows. 5 5
4 4
3 3
Yardeni
2 2
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
* 52-week forward consensus expected S&P 500 operating earnings per share divided by S&P 500 Index.
Monthly through March 1994, weekly after.
Figure 5.
26 26
25 FORWARD P/E & BOND YIELD 25
24 24
23 23
22 7/26 22
The S&P 500 P/E 21
Ratio Of S&P 500 Price To Expected Earnings*
21
(using expected 20 Fair-Value P/E=Reciprocal Of 20
earnings) is highly 19 Ten-Year U.S. Treasury Bond Yield 19
correlated with 18 18
reciprocal of the bond 17 17
yield. 16 16
15 15
14 14
13 13
12 12
11 Actual Fair 11
Jun 14 18.1 20.1
10 Jun 21 18.1 20.7 10
9 Jun 28 17.5 20.7 9
Jul 5 17.1 20.7
8 Jul 12 16.6 21.2 8
7 Jul 19 15.8 21.4 7
Jul 26 14.9 22.4
6 6
Yardeni
5 5
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.
- Earnings -
Figure 6.
75 75
S&P 500 EARNINGS PER SHARE CONSENSUS FORECASTS
(analysts’ average forecasts)
70 For 2001 For 2002 70
For 2003
Expected forward
65 65
earnings is a
time-weighted
average of current and
60 60 the coming years’
Forward consensus forecasts.
Earnings*
7/26
55 55
50 50
45 45
Yardeni
40 40
I II III IV I II III IV I II III IV
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.
Figure 7.
65 65
S&P 500 EARNINGS PER SHARE: ACTUAL & EXPECTED
60 60
S&P 500 Earnings Per Share
________________________
55 7/25 55
Forward Earnings* Bottom-up 52-week
50 (pushed 52-weeks ahead) 50 forward expected
Operating Earnings earnings tends to be a
45 (4-quarter sum) 45 good predicator of
Q1
actual earnings, with a
40 40
few significant misses.
35 35
30 30
25 25
20 20
15 15
Yardeni
10 10
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
weekly after.
- Earnings -
Figure 8.
75 75
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts)
70 01 02 70
Consensus Forecasts
__________________ 03
65 65
12-month forward
60 Annual estimates 00 60
99
Actual 4Q sum
Jul
55 98 55
50 50
97
45 96 45
40 40
95
35 91 94 35
92 93
30 30
25 25
Yardeni
20 20
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Analysts always start Source: Thomson Financial.
out too optimistic
about the prospects
for earnings.
Figure 9.
35 35
S&P 500 CONSENSUS OPERATING EARNINGS PER SHARE
(analysts’ bottom-up forecasts, ratio scale) 90
30 30
Consensus Forecasts
_________________
89
12-month forward
Annual estimates 88
25 25
Actual 4Q sum 85 87
86
82 83
20 84 20
81
80
15 15
Yardeni
10 10
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
- Earnings -
Figure 10.
25 25
S&P 500 EARNINGS PER SHARE
20 20
7/26
15 15 The data on
consensus expected
10 10 earnings can be used
to derive consensus
5 7/26 5
earnings growth
forecasts.
0 0
-5 -5
Consensus Growth
Forecasts*
_______________
-10 2001/2000 -10
2002/2001
-15 -15
2003/2002
Yardeni
-20 -20
I II III IV I II III IV I II III IV
2000 2001 2002
* Based on consensus expected S&P 500 operating earnings per share for years shown.
Figure 11.
45 45
S&P 500 OPERATING EARNINGS PER SHARE*
40 (yearly percent change) 40
35 Actual 35
30 Consensus Forecast 30 Earnings growth is
25 (Proforma)* Q4 25 highly cyclical.
20 20
15 15
10 10
5 5
0 0
-5 -5
-10 -10
-15 -15
-20 -20
-25 -25
Yardeni
-30 -30
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* S&P 500 composition is constantly changing. Actual data are not adjusted for these changes. Proforma
forecasts are same-company comparisions. Source: Thomson Financial.
- New Improved Model -
Figure 12.
2000 2000
FED’S STOCK VALUATION MODEL (FSVM-2)
1800 1800
This second version of 1600 1600

the Fed’s Stock .25
Valuation Model builds 1400 Actual S&P 500 1400
on the simple one by Fair Value S&P 500* .20

1200 1200
adding variables for 5-year earnings
long-term expected growth weight
_____________
1000 1000
earnings growth and .25 .10
risk. 800 .20 7/26 800
.10
600 600
400 400
200 200
Yardeni
0 0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* 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
Figure 13.
30 30
LONG-TERM CONSENSUS EARNINGS GROWTH*
(annual rate, percent)
Long-term earnings S&P 500

growth expectations 25 25
S&P 500 Information Technology
rose sharply during
1990s. They fell Ex Information Technology
sharply from
2000-2002. 20 20
Jul
15 15
Yardeni
10 10
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* 5-year forward consensus expected S&P 500 earnings growth. Data from 1995 based on new Global Industry
Classification Standard.
Figure 14.
40 40
MARKET’S WEIGHT FOR 5-YEAR CONSENSUS EXPECTED EARNINGS GROWTH*
(percent)
35 35
Weight market gives to long-term earnings growth
________________________________________
30 value > 13% = more than average weight 30 Investors have on
value < 13% = less than average weight
average over time
25 25 subtracted 13% of
their long-term
20 20
earnings growth
Average = 13% expectations from the
corporate bond yield
15 15
to determine earnings
Jun
yield.
10 10
5 5
0 0
Yardeni
-5 -5
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* 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.
Figure 15.
1.6 1.6
S&P 500 PEG RATIO
1.5 1.5
P/E ratio for S&P 500
divided by 5-year consensus Historically, S&P 500
1.4 expected earnings growth* 1.4 sold at P/E of 1.2 times
Jun long-term expected
1.3 1.3 earnings growth, on
average, with quite a
1.2
Average = 1.2
1.2
bit of volatility.
1.1 1.1
1.0 1.0
.9 .9
Yardeni
.8 .8
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* P/E using 12-month forward consensus S&P 500 expected earnings and prices at mid-month.
Figure 16.
12 12
CORPORATE BOND YIELD
(percent)
11 11
10 10
A-Rated
9 9
8 8
7 7/26 7
Yardeni
6 6
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Corporate bond yield
variable in FSVM-2 Source: Moody’s Investors Service.
captures risk that
earnings will be
weaker than expected.
Figure 17.
400 400
CORPORATE SPREAD*
(basis points)
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 50
Yardeni
0 0
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.
Figure 18.
- Global: Expected Earnings* -
65 325
UNITED STATES (S&P 500) GERMANY (DAX)
300
60
Jul 275
55
250
Jul
50 225
Expected EPS* Expected EPS
45 (dollars) (euros) 200
175
40
150
35
125
30 100
25 75
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
550 280
CANADA (TSE 300) FRANCE (CAC 40)
525
260
500
475 240
450 Jul Expected EPS
(euros) 220
425 Expected EPS Jul
(Canadian dollars) 200
400
375 180
350
160
325
300 140
275
120
250
225 100
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
360 70
UNITED KINGDOM (FT 100) JAPAN (TOPIX)
340
320 60
300 Expected EPS Expected EPS

(pounds) (yen) 50
280
Jul
260
40
240
220 Jul
30
200
Yardeni
180 20
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
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial.
- Global: Stock Valuation -
Figure 19.
80 80
UNITED STATES
60 60
40 Overvalued 40
20 20
0 0
Jun
-20 -20
Undervalued
-40 -40
1995 1996 1997 1998 1999 2000 2001 2002 2003
50 50
CANADA
30 Overvalued 30
10 10
-10
Jun -10
Undervalued
-30 -30
1995 1996 1997 1998 1999 2000 2001 2002 2003
40 40
UNITED KINGDOM
20 Overvalued 20
Jun
0 0
-20 Undervalued -20
-40 -40
1995 1996 1997 1998 1999 2000 2001 2002 2003
80 80
GERMANY
60 60
40 Overvalued 40
20 20
0 0
Jun
-20 Undervalued -20
-40 -40
1995 1996 1997 1998 1999 2000 2001 2002 2003
60 60
FRANCE
40 40
20 Overvalued 20
0 0
Jun
-20 Undervalued -20
-40 -40
1995 1996 1997 1998 1999 2000 2001 2002 2003
200 200
JAPAN
150 150
100 100
Overvalued
50 50
0 0
-50 -50
Yardeni Undervalued Jun
-100 -100
1995 1996 1997 1998 1999 2000 2001 2002 2003
Figure 20.
- Global: United States (S&P 500) -
160 70
STOCK VALUATION MODEL
150
60
140 Jul
130 50
Industrial Production
120 (1987=100)
40
110
100 30
90 Expected Earnings Per Share* 20
80 For S&P 500 (dollars)
70 10
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 30
25 25
Fair-Value P/E
20 Jun 20
Forward P/E
15 15
10 10
5 5
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
1825 1825
1475 1475
1125 1125
Stock Price Index (S&P 500) Jun
Fair-Value Price
75 75
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 70
60 60
50 50
40 40
30 30
Overvalued
20 20
10 10
0 0
-10 Jun -10
-20 -20
-30 Undervalued -30
Yardeni
-40 -40
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
Figure 21.
- Global: Canada (TSE 300) -
120 550
STOCK VALUATION MODEL 525
115 Apr
Expected Earnings Per Share 500
110 for TSE 300 (Canadian dollars) 475
Jul 450
105
425
100 400
95 375
350
90 325
85 Industrial Production 300
(1997=100) 275
80
250
75 225
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
24 24
22 22
Fair-Value P/E
20 Forward P/E 20
18 18
Jun
16 16
14 14
12 12
10 10
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
12500 12500
10500 10500
Stock Price Index (TSE 300)
Fair-Value Jun
4500 4500
2500 2500
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
50 50
40 40
30 30
20 Overvalued 20
10 10
0 0
Jun
-10 -10
-20 Undervalued -20

Yardeni
-30 -30
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
* Source: Thomson Financial.
Figure 22.
- Global: United Kingdom (FT 100) -
110 350
105
300
100
(1995=100) 250
95
Jul
200
90 Expected Earnings Per Share
for FT 100 (pounds)
85 150
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
25 25
23 23
21 Fair-Value P/E 21
19
Jun 19
Forward P/E
17 17
15 15
13 13
11 11
9 9
7 7
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
7900 7900
7100 7100
6300 Stock Price Index (FT 100) 6300
4700 Jun 4700
Fair-Value
3100 3100
2300 2300
1500 1500
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
40 40
30 30
20 Overvalued 20
10 10
Jun
0 0
-10 -10
Undervalued
-20 -20
Yardeni
-30 -30
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Figure 23.
- Global: Germany (DAX) -
120 325
300
275
Jul 250
110 Industrial Production
(1995=100) 225
200
175
100
150
Expected Earnings Per Share 125
for DAX (Euros) 100
90 75
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
34 34
32 32
30 30
26 Forward P/E 26
24 24
22 22
20 Jun 20
18 18
16 16
14 14
12 12
10 10
8 8
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
11000 11000
9000 9000
7000 Stock Price Index (DAX) 7000
(ratio scale)
5000 5000
Fair-Value Jun
(ratio scale)
3000 3000
1000 1000
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
80 80
60 60
40 Overvalued 40
20 20
0 0
Jun
-20 -20
Undervalued
Yardeni
-40 -40
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Figure 24.
- Global: France (CAC 40) -
120 275
118
250
116
114 225
112 Jul
110 200
108 (1995=100) 175
106
104 150
for CAC 40 (Euros) 125
100
98 100
1995 1996 1997 1998 1999 2000 2001 2002 2003
29 29
27 27
23 Forward P/E 23
21 21
19 Jun 19
17 17
15 15
13 13
11 11
1995 1996 1997 1998 1999 2000 2001 2002 2003
7900 7900
7100 7100
6300 6300
5500 5500
4700 Stock Price Index (CAC 40) 4700
(ratio scale)
3900 Jun 3900
Fair-Value
2300 2300
1500 1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
60 60
40 40
20 Overvalued 20
0 0
Jun
Undervalued
-20 -20
Yardeni
-40 -40
1995 1996 1997 1998 1999 2000 2001 2002 2003
Figure 25.
- Global: Japan (TOPIX) -
115 60

for TOPIX (yen) 50
105 Industrial Production Jul

(1995=100) 40
100
Jun 30
95
90 20
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
150 150
Fair-Value P/E
100 100
Forward P/E
Jun
50 50
0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
4500 4500
4000 4000
3500 3500
3000 3000
Stock Price Index (TOPIX)
2500 2500
Fair-Value
2000 2000
1500 1500
1000 Jun 1000
500 500
0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
300 300
200 200
Overvalued
100 100
0 0
Undervalued
Jun Yardeni
-100 -100
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
- Earnings: US vs G5 -
Figure 26.
65 300
S&P 500 & G5 FORWARD EARNINGS
60
S&P 500 Forward Earnings*
55
7/26 250
G5 Forward Earnings** Jul
50
45 200
40
35 150
30
Yardeni
25 100
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
* 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994, Close correlation
weekly after.
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada, between US and G5
France, Germany, Japan and United Kingdom. Source: Thomson Financial. profits cycle.
Figure 27.
30 30
S&P 500 & G5 FORWARD EARNINGS
(yearly percent change)
20 20
10 10
0
Jul 0
-10 -10
Jul
-20 -20
G5 Forward Earnings**
Yardeni
-30 -30
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
** Unweighted average of the 12-month forward consensus expected operating earnings per share for Canada,
France, Germany, Japan and United Kingdom. Source: Thomson Financial.
- Earnings & Output: US -
Figure 28.
65 160
S&P 500 EARNINGS & INDUSTRIAL PRODUCTION
60
150
55 7/26
Jun 140
50 S&P 500 Forward Earnings*
130
45 Industrial Production
(1992=100)
40 120
35 110
30
100
25
90
20
80
15
10 70
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
Strong correlation * 52-week forward consensus expected S&P 500 operating earnings per share. Monthly through March 1994,
between US industrial weekly after
production and S&P Source: Thomson Financial.
500 forward earnings.
Figure 29.
30 30
S&P 500 EARNINGS & PRODUCTION
25 25
20 20
15 15
10 10
5 5
0 7/26 0
-5 -5
-10 S&P 500 Forward Earnings* -10

-15 -15
-20 -20
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
weekly after
- Earnings & Prices: US -
Figure 30.
30 30
S&P 500 EARNINGS & PRODUCER PRICE INDEX
25 25
20 20
15 15
10 10
5 5
0 7/26 0
Jun
-5 -5
-10 PPI: Intermediate Goods -10

-15 -15
Yardeni
-20 -20
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 Profits cycle is highly
correlated with pricing
cycles especially with
the intermediate
goods PPI and import
Figure 31. prices.
25 25
S&P 500 EARNINGS & US IMPORT PRICES
20 20
Import Price Index
15 15
10 10
5 5
0 7/26 0
Jun
-5 -5
-10 -10
-15 -15
Yardeni
-20 -20
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
* 12-month forward consensus expected operating earnings per share. Source: Thomson Financial, US
Department of Labor, Bureau of Labor Statistics.
- Earnings & Output: Europe -
Figure 32.
120 275
FRANCE: EARNINGS & PRODUCTION
118
May
116 250
114
Forward Earnings*
112 225
110 Industrial Production Jul

(1995=100)
108 200
106
104 175
102
100 150
98
96 125
94
Yardeni
92 100
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Industrial production * 12-month forward consensus expected earnings per share for CAC 40.
is key variable driving Source: Thomson Financial.
profits in France and
UK.
Figure 33.
110 340
UNITED KINGDOM: EARNINGS & PRODUCTION
108
320
106
300
104
102 May 280
100
260
98
Forward Earnings*
96 240
94 (1995=100) Jul 220
92
200
90
Yardeni
88 180
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
* 12-month forward consensus expected earnings per share for FT 100.
- Earnings & Output: Japan -
Figure 34.
115 60
JAPAN: EARNINGS & PRODUCTION
Forward Earnings*
110
50
(1995=100)
105 Jul
40
100
Jun
30
95
Yardeni
90 20
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
* 12-month forward consensus expected operating earnings per share for TOPIX. Japan’s profits cycle
driven by
manufacturing.
Figure 35.
100 60
JAPAN: EARNINGS & TANKAN BUSINESS CONDITIONS
75 Forward Earnings*
Tankan Business Conditions: 50

Major Manufacturers
50 (diffusion index)
Jul
25 40
30
-25
Q1
Yardeni
-50 20
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
* 12-month forward consensus expected earnings per share for TOPIX.
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Asset Valuation Allocation Models

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R e s e a r c h Asset Valuation & Allocation

July 30, 2002

Dr. Edward Yardeni

On December 5, 1996, Alan Greenspan, Chairman of the Federal Reserve Board,

Of course, in the investment community, we tend to follow the price-to-earnings ratio

II. New Improved Model

3) FEY = CBY – b · · LTEG

Equation 3 can be rearranged to produce the following:

4) FVP = E ¸ ¸ [CBY – b · · LTEG]

III. Back To Basics

IV. Stocks Versus Bonds

Bonds/Stocks Asset Allocation Model

According to the Fed

-20 Undervalued -20

This second version of 1600 1600

on the simple one by Fair Value S&P 500* .20

Long-term earnings S&P 500

300 Expected EPS Expected EPS

-20 Undervalued -20

-20 Undervalued -20

110 Expected Earnings Per Share

105 Industrial Production Jul

-10 S&P 500 Forward Earnings* -10

-10 PPI: Intermediate Goods -10

110 Industrial Production Jul

102 May 280

Tankan Business Conditions: 50

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