Blog - Investing Notes

Blog Synthesis: Gunning for the Fed Model?

Here is a listing of past blog entries that summarize recent critique of and support for the Fed Model and its variants (including our Real Earnings Yield Model).

Predictive Power of the Gap Between Stock Earnings Yield and T-note Yield ...investors may be able to use the Fed Model to enhance risk-adjusted returns via reduced portfolio volatility.

Stock Market Earnings Yield and Inflation Over the Long Run ...long-run data offers stronger evidence for a stock market model based on the real earnings yield than for a model that compares the earnings yield to the long-term bond yield. It also suggests: (1) a substantial structural break in the relationship between earnings yield and inflation about 1960; and, (2) the possibility of using real earnings yield variability in estimating an expected real earnings yield.

Kicking the Body of the Fed Model ...investors seem to have left the Fed model for dead.

Real Earnings Yield Model Scenarios ...this Fed model-like stock market valuation forecast is currently much more sensitive to beliefs about future corporate earnings than beliefs about future inflation.

Macroeconomic Shocks and the Stock Market ...inflation shocks significantly affected the U.S. stock market over the past half century, with disinflation (inflation) shocks increasing (decreasing) stock prices and promoting boom (bust) conditions.

Inflation as Fed Model Intermediator ...the high correlation between equity yield and bond yield derives rationally from the tendency for inflation to be elevated during recessions, such that both equity and bond premiums are relatively high during recessions.

Still Irrationally Exuberant? ...Changing public beliefs in how the economy works (and thereby valuation models) substantially affect long-term interest rates and asset prices. Current beliefs, focused on nominal rather than real interest rates, foster irrational overpricing of assets.

What Would the Fed Model Do? ...the Fed model says that substantial movements of stock prices (up), earnings (down) and/or T-bill and T-note yields (up) must occur to produce "normal" stock-Treasuries yield spreads.

A Fed Model Defense ...the author finds that the Fed model and the long-term P/E mean reversion model are complementary perspectives on return prediction, with the former reasonably useful for forecasting up to three years into the future and the latter applicable over longer horizons.

Reader Question on the "Tired" Bull Market ...we know of no way to forecast either the size or duration of stock market trends (or trend reversals) that is reliable enough for successful market timing. Fundamentals (production, consumption, earnings, dividends, interest rates) matter, but lack of compelling theory keeps the forecasters chasing data.

Out-of-Sample Test for a Stock Market Model ...investors/traders pivot on earnings, but react to the inflation rate rather than interest rates.

Last Nail in the Coffin of the Fed Model? ...practitioners who use the Fed Model are simpletons. The model is theoretically implausible and empirically challenged.

T-note Yield Conundrum Weakening the Fed Model? ...foreign recycling of dollars from the extremely large current trade deficit into a safe haven may be the force holding down the T-note yield, but the most plausible expectation is that the gap between T-note and T-bill yields will normalize.

International Fed Model Test ...while changes in bond yields have short-term effects on stock prices, valuation ratios better forecast long-term stock market behavior.

March Madness: Fed Model Upsets P/E Model ...the Fed Model better describes the behavior of the market P/E over the past forty years than does a mean-reverting model.

50-Year Fed Model Meme? ...the Fed Model has worked pretty well starting about 1960, with interest rates since playing a key role in stock valuation.

One Up on the Fed Model? ...individual investors may be able to outperform through determined reinvestment of dividends and exploitation of capital gains mean diversion and reversion.

Earnings Yield-Interest Rate Spread: The Good News? ...the gap between the S&P 500 earnings yield and Treasury instrument yields has some market timing value, with short spreads outperforming long spreads.

Fed Model: Predictive or Not? ...the Fed model is inferior to fundamental valuation in predicting long-term stock returns, but it may have some tactical value.