Fed Model

In their April 2002 paper entitled “Solving the Price-Earnings Puzzle” Carl Chiarella and Shenhuai Gao investigate the interrelationships of stock prices (the S&P 500 index), earnings and interest rates (the Federal Funds Rate) during January 1979 to August 2001. They conclude that the stock index is proportional to aggregate earnings and inversely proportional to the interest rate. Using data for these variables since January 1990,  we find that: More…

Fed Model proponents argue that there is an equilibrium relationship between the earnings yield of a stock index and the 10-year government bond yield. When the earnings yield is below (above) the 10-year government bond yield, the stock market is overvalued (undervalued). In his January 2006 paper entitled “The Fed Model: The Bad, the Worse, and the Ugly”, Javier Estrada recaps the (lack of) theoretical basis for the Fed Model and tests its empirical support in the markets of 20 countries. Using both actual (trailing) and projected (forward) earnings for total market indices over various periods ending in June 2005, he concludes that: More…

Fed Model proponents argue that there is an equilibrium relationship between the earnings yield of a stock index and the 10-year government bond yield. When the earnings yield is below (above) the 10-year government bond yield, the stock market is overvalued (undervalued). In their August 2005 working paper entitled “An International Analysis of Earnings, Stock Prices and Bond Yields”, Alain Durré and Pierre Giot assess the relationships among stock index prices, earnings and long-term government bond yields for 13 countries (Australia, Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Switzerland, The Netherlands, United Kingdom and the United States) over a 30 year period. Using current earnings for total market indexes over the period 1973-2003, they conclude that: More…

Conventional wisdom says that high market P/E ratios forecast negative future stock returns. In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion,” Robert Weigand and Robert Irons to test this conventional wisdom. Using data back to the 1880s, they pit the Fed Model against the P/E mean reversion model to determine which one better explains stock market behavior. They find that: More…

Is the Fed Model a useful market timing tool? In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion”, Robert Weigand and Robert Irons investigate whether very high price/earnings (P/E) ratios foreshadow poor future stock market performance. Using data over the very long period from 1881 to 2002, they find that: More…

In their June 2003 paper entitled “A General Theory of Stock Market Valuation and Return”, Christophe Faugere and Julian Van Erlach contend that past stock returns are overstated and develop a market valuation formula that out-fits the Fed Model. Specifically, they show that: More…

In his May 2002 paper entitled “Market Timing Strategies that Worked”, Pu Shen evaluates the effectiveness of the spreads between the S&P 500 index earnings yield (the earnings/price ratio or E/P) and the yields on 10-year Treasury notes (T-note) and 3-month Treasury bills (T-bill) as market timing indicators. By constructing “horse races” between switching strategies that call for investing in the stock market index unless spreads are lower than predefined thresholds during 1970-2000, he concludes that: More…

Many investors monitor the Fed Model, based on the relationship between the earnings yield of stocks and the bond yield, for long-term stock market timing signals. Does this model really work? Notable contrary arguments are found in the December 2002 paper entitled “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns” by Clifford S. Asness and the 2004 paper entitled “A Tactical Implication of Predictability: Fighting the Fed Model” by Roelof Salomons. These two papers present similar analyses and conclusions, as follows: More…