Fed Model

…evidence from several simple tests does not support a belief that the Fed Model explains investor behavior over the past 20 years.

…investors may be able to use the Fed Model to enhance risk-adjusted returns via reduced portfolio volatility.

…investors seem to have left the Fed model for dead.

…long-term stock market timing models may enhance investment returns, especially on a risk-adjusted basis. Which model is best depends on the risk-adjustment metric used.

…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.

…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.

…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.

…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.

…the author provides a comprehensive overview of equity risk premium concepts and values, stressing the mid-20th century break in key financial relationships.

…investors/traders may pivot on earnings, but appear to react to the inflation rate rather than interest rates.

…practitioners who use the Fed Model are simpletons. The model is theoretically implausible and empirically challenged.

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

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

…the Fed Model has worked pretty well starting about 1960, with interest rates since playing a key role in stock valuation.

…individual investors may be able to outperform through determined reinvestment of dividends and exploitation of capital gains mean diversion and reversion.