I’ve long argued that stock valuations can be good long-term predictors of returns, but they don’t do much good in the short term. A stock, or an index of stocks, can be extremely undervalued or overvalued for an extended period. This article dives into the details of two models, the Fed Model and the Shiller CAPE model. It founds that neither is good in helping time asset allocation, though the Fed model worked reasonably well until about 2010.
Thought leaders in the space debate the merits of the different approaches. For example, at the 70th Annual CFA Institute Conference in 2017, there was a heated debate between Robert Shiller and Jeremy Siegel on whether the US stock market is overvalued(1). On the one hand, Robert Shiller, the distinguished Yale economist and Nobel Laureate, claimed that the US stock market is highly overvalued judging by the current CAPE ratio. On the other hand, Jeremy Siegel, the author of “Stocks for the Long Run”, remarked that, given the extremely low-interest rates, the US stock market is not overvalued. Janet Yellen, the previous Fed Chair, held the same opinion as Jeremy Siegel. In particular, at the end of 2017, she said that “the low-rate environment is supportive of higher CAPE ratio.” Apparently, both Jeremy Siegel and Janet Yellen use the Fed model to determine whether the US stock market is overvalued.