Kicking the Body of the Fed Model

As with many indicators, the Fed Model is presently so far out of multi-generational bounds that reversion seems hopeless. Is the body still warm, or ready for burial? Using the daily S&P 500 earnings yield (E/P) during 1/2/90-12/4/08, as calculated from the historical S&P 500 index and 12-month trailing Standard & Poor’s earnings data, and contemporaneous daily 10-year Treasury note (T-note) yields, we find that…

The following chart compares E/P based on 12-month trailing earnings and the T-note yield over the entire sample period. A long-term change occurs in 2002, after which investors require an E/P greater than (rather than less than) the T-note yield. As of 12/3/08, E/P based on 12-month trailing earnings (7.86%) is about 5.3% higher than the T-note yield (2.57%). E/P based on the current Standard & Poor’s estimate of 12-month forward earnings for the S&P 500 is 9.44%, about 6.9% higher than the current T-note yield. For this forward E/P to equal the T-note yield:

• The S&P 500 index would have to advance to about 3100; or,
• Standard & Poor’s projections for S&P 500 earnings the next 12 months would have to fall by about 73%; or,
• The T-note yield would have to increase by a factor of 3.7.

In summary, investors seem to have left the Fed model for dead.

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