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The Fed Model
By Vasco Laranjo, CFA
The US stock market keeps pushing higher despite recessionary warnings. S&P 500 Index earnings for the most recent quarter are estimated to have risen, albeit at a slower pace than stock prices. As a result, valuations rose, with the P/E estimated at 24.43. 1 On the other hand, U.S. Treasury bond yields reached levels not seen in more than 10 years following the current Fed’s rate hike campaign. This comeback of the bonds challenges the former environment of TINA (there is no alternative – to stocks) to mutate to TARA (there are reasonable alternatives). In this article, I will present a tool to assess whether the stock market is fairly priced.
The Fed Model
The Fed Model, also known as the Fed Stock Valuation Model, is a stock valuation model published in the late 1990s and attributed to Ed Yardeni. In its original form, it compares the earnings yield (E/P ratio) of the S&P 500 Index to the yield on 10-year U.S. Treasury bonds. Whenever the earnings yield is higher than the yield on 10-year U.S. Treasury bonds, the stock market is undervalued. If, on the other hand, the earnings yield is lower than the yield on the 10-year U.S. Treasury bond, the stock market is overvalued:
Last year, the yield on 10-year U.S. Treasury bonds reached 4%, a level not seen since 2008. 2 At the same time, corporate earnings in the S&P 500 Index began to decline last year, which was also reflected in stock prices as the stock market had a P/E ratio between 20 and 22. However, the recovery of the stock market observed in the first half of 2023 was not accompanied by the increase in profits. As a result, the P/E ratio of the S&P 500 Index is estimated to be 24.43 at the beginning of June. 3 This represents an earnings yield of approximately 4.1%, close to the yield on 10-year U.S. Treasury bonds of 3.6% at the beginning of June. 4 As can be seen in the chart below, these values have not been this close since 2009:
Source: Federal Reserve Bank of St. Louis, multipl.com, as of May 31, 2023. Past performance is not a reliable indicator of future performance.
After a decade of persistently low Treasury yields, which led to the stock market being considered undervalued according to the Fed’s model, the situation is currently quite different. The spread between the earnings yield of the S&P 500 Index and the yield on 10-year US Treasury bonds is the lowest it has been since the Great Financial Crisis. If the current trend continues, the model could soon indicate that the stock market is overvalued.
The model seemed spot on during the GFC when it raised the “overvaluation flag” from May 2008. It also signaled an overvalued stock market throughout the dotcom bubble crash, only becoming undervalued from October 2003, shortly after the stock market began to recover. Nevertheless, the Fed model constantly indicated that the stock market was overvalued in the 1980s and 1990s. During this period, the stock market rose more than 10-fold from $108 to $1,469. 5 So it would clearly be unwise to follow the model during this period.
This discussion got me thinking about the position of the stock market in other countries. Are they also on the verge of being considered overvalued? Are they already overvalued? Or are they still undervalued?
Current Valuations in Other Countries
In early 2023, Warren Buffet turned his attention to Japan in his quest for new investment opportunities. Ray Dalio’s Bridgewater Associates 13F showed that his hedge fund largest position was in emerging markets via an ETF. So maybe there are some opportunities away from the US. What does the Fed model have to say about this?
Source: investing.com, msci.com, as of May 31, 2023. Past performance is not a reliable indicator of future performance.
From the table above, we can see that most countries’ equity markets are considered undervalued, with the exception of New Zealand, South Africa and India. Indeed, Japan has a solid spread between its earnings yield and its 10-year bond yield of 5.6%, which contrasts with the 0.5% in the US. Moreover, some emerging markets such as Turkey, Brazil, South Korea and China are considered undervalued, with a significant margin in the aforementioned range. Alternatively, India appears to be a place where the bond market may provide a solid competitor to the stock market.
Final Notes
As noted above, the Fed model clearly missed the strong bull markets of the 1980s and 1990s. This result strongly questions the validity of the model. Nonetheless, at a moment when the US is on the verge of crossing the line from undervalued to overvalued, it might be prudent to at least reconsider the TINA motto.
Finally, Ed Yardeni has also extended the Fed model discussed to the well-known Yardeni model. The Yardeni model incorporates the expected earnings growth rate into the analysis. The results of these models are regularly updated and published on Yardeni’s website at here.
Sources
1 Source: multipl.com, as of June 29, 2023
2 Source: Federal Reserve Bank of St. Louis, as of June 29, 2023
3 Source: multipl.com, as of June 29, 2023
4 Source: Federal Reserve Bank of St. Louis, as of June 29, 2023
5 Source: investing.com, as of June 29, 2023
Data Source:
FRED Board of Governors of the Federal Reserve System (US), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/
Code Source: GitHub Page
Cover Image Credits: © erik forsberg/ ID: 15933611724 / Flickr.com
Disclosure:
The information provided on Vasconomics.com is for general informational purposes only and should not be construed as financial advice. The content on this blog is based on the author’s personal opinions and research, and it may not be applicable to your individual financial situation. It is always recommended to consult with a qualified financial professional or advisor before making any financial decisions. The author and Vasconomics.com disclaim any liability for any losses or damages incurred as a result of the information provided on this blog.