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Tuesday, August 24, 2010

BTIG Fed Model With VIX Risk Adjustment

This model was discussed in a very long but interesting article by Doug Kass posted on the Wennerstrom Semi Equipment Analysis forum at Silicon Investor. Kass makes two major points:
#1 Kass is bullish now. Kass expects the market (S&P500 Quote and Charts) to trade between 1020 and 1150 (roughly between 11x and 13x 2011 S&P EPS forecasts). At 1075 "there is approximately 55 S&P points of risk and about 75 S&P points of upside. In other words, the scale has now tipped back to the bullish side."
Last year Kass called for a "generational low" in March 2009. With the market now in the 1050s, there is even more upside and less downside left.
#2 Kass says "Stocks Are Extraordinarily Cheap Against Interest Rates.
* For the first time since 1962, the yield on the Dow Jones Industrial Average exceeds that of bond yields.
* Risk premiums (the difference between the earnings yield of the S&P index and the 10-year U.S. note) is at the highest level since the beginning of the modern era's bull market that began in the early 1980s.
* Nearly four-fifths of the companies contained in the S&P 500 index possess earnings yields that are greater than bond yields. And many have (growing) dividend yields that are similar to their own bond yields.

*The BTIG Fed Model says equities are nearly as compelling (last week) as they were in March 2009 when Kass said the market was making a "generation low."
More on BTIG Fed Model:
 This is how Kass explains the BTIG Fed Model
The "BTIG Fed Model" attempts to place a more conservative and defensive twist on the traditional Fed Model. When the levels of risk and fear rise in the financial market, Treasury Bonds represent the safe haven for investors and Equities are a proxy for risk. Thus, Treasuries become expensive relative to Equities, but that heightened level of risk is the obvious reason for that shift.

In order to account for the fear risk, in the BTIG Fed Model, we use the Vix in conjunction with the 10 Year Treasury Yield to raise the threshold with which Equities must compete. During these episodes of heightened fear, the Vix traditionally moved inversely with the 10 year Treasury yield. The Vix rises with the volatility and Treasury yields contract due to a flight to quality. Thus by taking the Vix and dividing by 10 and adding it to the 10 Treasury yield, we derive a larger number representing bonds not only reflecting the expected cash flow, but also adjusting for the heighted level of risk investors perceive in equities. Then comparing this "higher bar" to the S&P 500 earnings yield, one is comparing this relationship on a more conservative basis for equity investors. Additionally, we are using trailing S&P 500 earnings yield, which is also more conservative than using forward estimates.

What is extremely noteworthy about this metric in the current environment is that the level of equity undervaluation relative to Treasuries today using this model is equivalent to the extreme levels registered in early March of last year.
I cover the simple "Fed Model" in "Kirk Lindstrom's Investment Letter" but I sure like the added value of the BTIG Fed Model.

Kass's belief that the market is a good trade here aligns well with much of my own thinking and work.  So much so that I was a buyer of equities earlier this morning for my personal portfolio and my newsletter "explore portfolio."  I alerted my subscribers via email what I bought.

Since 12/31/98 "Kirk's Newsletter Explore Portfolio" is UP 152% (a double plus another 52%!!) vs. the S&P500 UP a tiny 5.7% vs. NASDAQ Comp  down 0.6%!   (All through 8/22/10)

In 2009, "Kirk's Newsletter Explore Portfolio" gained 33.5% vs. the DJIA up 18.8%

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  1. Charles Nenner correctly called the market top back in 2007 and the subsequent rally that we just had from the March 2009 low. He also called an end to the rally back in April of this year. He sees DOW 5000 in the next 2 years or so.

  2. Yes, I posted a summary of Neemer's advice at

    Charles Neener Predicts DOW 5,000

    I always like to give balance when possible.


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