The Flaws in the Fed Model

Found via The Big Picture.

There are perfectly reasonable arguments that can support an upbeat outlook on the stock market. Unfortunately for crafters and consumers of sound bites, one of the simplest and most popular bullish assertions is irrelevant.

This is the common, intuitive, yet specious claim that because yields on 10-year Treasury notes are near record lows at 1.64%, stocks are so flattered into appearing cheap by comparison that surely they must rise. The only way to watch an hour of financial television without hearing that one is to hit the mute button.

The idea here, once formalized as the "Fed Model," is that stocks' "earnings yield" (reported or forecast operating earnings for the S&P 500, divided by the index level) should tend to track the Treasury yield in some fashion. With this earnings yield now above 7%, based on a trailing price-to-earnings ratio near 13, this model and its various offshoots render equities a no-brainer buy. Or, if one prefers, that Treasuries are in a reason-defying bubble.

This simply doesn't hold up in theory or practice. The Fed Model only "worked" as a predictor of market action in the 1980s and '90s, when bond yields were steadily descending and stock values consistently rising as inflation and interest rates were slowly strangled. Both before that period and since, the Fed Model relationship has been mostly a non sequitur in terms of foretelling market performance.

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Related previous post: Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns - By Cliff Asness (December 2002)