Fed Model

The "Fed model" is a theory of equity valuation that has found broad application in the investment community. The model compares the stock market’s earnings yield (E/P) to the yield on long-term government bonds. In its strongest form the Fed model states that bond and stock market are in equilibrium, and fairly valued, when the one year forward looking earnings yield equals the 10-year Treasury note yield :

The model is often used as a simple tool to measure attractiveness of equity, and to help allocating funds between equity and bonds. When for example the equity earnings yield is above the government bond yield, investors should shift funds from bonds into equity. The Fed model was so named by Ed Yardeni, at Deutsche Morgan Grenfell, based on a statement made in the Humphrey-Hawkins report of July 22, 1997 issued by the Federal Reserve that warned:

“…changes in this ratio have often been inversely related to changes in the 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.”

The Fed model was never officially endorsed by the Fed, but former Fed chairman Alan Greenspan seemed to make reference to it in his memoirs: “The decline of real (inflation adjusted) long-term interest rates that has occurred in the last two decades has been associated with rising price-to-earnings ratios for stocks, real estate, and in fact all income-earnings assets.” A bond yield versus equity yield comparison has been used in practice long before the Fed published the graph and Yardeni gave it a name. A variant of this, first the expected AAA bond yield from the Blue Chip survey verusus the forward-earnings yield on the S&P 500, and then later versus the 10-year Treasury was developed by Dirk van Dijk at I/B/E/S in the mid 1980's.