Fed Model

The Fed Model is a valuation technique where the yield on an investment in stocks is compared against the yield on government bonds. The yield on the investment is calculated over 12 months and is typically compared to the yield on a 10-year U.S. Treasury bond.

This evaluation of the yield gap outperforms rival predictors in its forecasting of favorable excess market returns. The method does so for short- and long-forecasting horizons and similarly for equal-weighted and value-weighted stock indices. Sharpe ratios considerably rise when employing an investment strategy based on the predicting propensity of the yield gap.

Key Takeaways                                                               

• The Fed Model is a valuation technique where the yield on an investment in stocks is compared against the yield on government bonds. It is calculated over 12 months and is typically compared to a 10-year U.S. Treasury bond yield.
• Comparison between actual variables (earnings yield) and nominal variables (bond yield) is not possible, due to which many have questioned the Fed model's theoretical viability as a stock valuation model.
• Other measures that can be considered as alternatives include the price-to-earnings ratio (P/E ratio), price-to-sales ratio (P/S ratio), and the proportion of household equity to total financial assets.

The Fed's model derives its results by contrasting the yields on the 10-year Treasury note with the S&P 500's price-to-earnings ratio based on anticipated operating earnings in the following 12 months. The Fed model asserts that long-term bonds and stocks compete with one another in investments such as pension funds and insurance companies. Here the earnings or dividend yields on stocks should be roughly equal to those on nominal bonds or, at the very least, should be strongly correlated.

The earnings yield of a stock is determined by dividing the company's earnings per share by its current market price per share. It represents the return an investor can expect to earn from owning the stock. On the other hand, the yield on 10-year Treasury bonds reflects the interest rate paid by the government on these bonds.

According to the Fed Model, stocks are considered relatively more attractive when stocks' earnings yield is higher than Treasury bonds' yield. Investors can earn a higher return by investing in stocks than bonds.

Conversely, stocks may be less attractive if stocks' earnings yield is lower than Treasury bonds' yield. In such cases, investors prefer the stability and fixed income of Treasury bonds.

However, using the Fed Model alongside other valuation and market indicators is crucial, as it has limitations and does not provide a comprehensive view of the stock market.

Investors will select the security with the highest yield when making investment decisions. The S&P 500's earnings yield is determined by dividing the index's annual earnings per share by the index's current market price per share. The model predicts bullish market sentiment if the S&P 500 earnings yield exceeds the 10-year U.S. Treasury bond yield. It means that investors are optimistic about the economy and the prospects of the S&P 500 companies.

Alternatively, when the model predicts a bearish market atmosphere if the S&P 500 earnings yield falls below the 10-year U.S. Treasury bond yield, it shows that investors are not optimistic about the economy or companies' future within the S&P 500. Therefore, investors must gather data on stock market earnings and the 12-month yield of 10-year Treasury bonds. Then they shall compare the two figures, plan an investment strategy, and use other factors (company performance, market trends, etc.) to arrive at the same conclusion.

Some of the alternative measures that can be used are:

#1- Price-To-Earnings Ratio

The price-to-earnings (P/E) ratio, which contrasts a stock's price with its earnings per share, is an alternative to the Fed Model. It can assist investors in determining whether a business is overvalued or undervalued. A stock may be overpriced if its P/E ratio is high, whereas a stock may be undervalued if its P/E ratio is low. However, the ratio may not be reliable for valuing businesses in specific industries.

#2- Price-To-Sales Ratio

The price-to-sales (P/S) ratio, which compares a corporation's market capitalization and revenue, is another option for the Fed Model. It helps in assessing whether a company's stock is overvalued or undervalued. A high P/S ratio may indicate an overvalued stock, while a low P/S ratio may suggest an undervalued stock. However, similar to the P/E ratio, the P/S ratio may not be reliable for valuing businesses with low-profit margins.

#3- Household Equity as a Percentage of Totals Financial Assets

It examines home equity as a proportion of total financial assets. A high percentage of household equity to total financial assets may imply that investors are bullish regarding the stock market. In contrast, a low rate may signal investors to expect it to be bearish. However, it may not accurately predict the sentiments.

There are several restrictions before using the model to make investing decisions. 

1. Inflation Consideration: Inflation is one such factor; it is considered in the stock market's earnings yield but not in the yield on Treasury bonds. It is called the "money illusion" and may cause the Fed Model to make incorrect forecasts.
2. Assumption of Identical Yield Rates: The Fed Model assumes that the earnings yield and bond yield rates are identical, although it does not aim to provide an accurate market assessment. This assumption is made to put stocks and bonds on an equal footing for comparison. However, since the model compares actual (earnings yield) and nominal variables (bond yield), some have questioned its theoretical viability as a comprehensive stock valuation model.

The Fed and Yardeni models are two distinct approaches to stock market valuation, each with its methodology and focus. Let's understand the differences between them:

• The Yardeni model is a stock market valuation model developed by economist Ed Yardeni, while the Fed model is a stock valuation technique associated with the Federal Reserve.
• The Yardeni model focuses on the relationship between corporate profits and stock prices, considering earnings growth and interest rates. In contrast, the Fed model compares the yield on stocks to the yield on government bonds.
• The Yardeni model considers a broader range of fundamental and macroeconomic variables, including inflation, interest rates, and earnings forecasts, to determine stock market valuations. The Fed model primarily compares the earnings yield of stocks to the yield on Treasury bonds.
• The Yardeni model incorporates forward-looking elements and considers a longer time horizon for assessing stock market valuation. In contrast, the Fed model often focuses on the current earnings yield and bond yield ratios.