Testing the Fed Model

The key guiding belief of the Fed Model of stock market valuation is that investors use a Treasury note (T-note) yield as a benchmark for the expected (forward) earnings yield of the stock market. When the gap between the forward earnings yield and the T-note yield is positive (negative), stocks are relatively attractive (unattractive), and investors bid stocks up (down) to restore yield parity. To test that belief, we relate the gap between the S&P 500 1-year forward earnings yield and the 1-year T-note yield to future returns for the S&P 500 index. We calculate the 1-year forward earnings yield from the Earnings Forecast and the level of the S&P 500 Index. Using end-of-month data for the two yields over the period March 1989 (limited by availability of an input variable for the Earnings Forecast) through August 2010 (21+ years), we find that: (more…)