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Fed Model: Predictive or Not?

| | Posted in: Fundamental Valuation

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:

  • Investors should use fundamental measures of valuation, such as the price/earnings (P/E) ratio, for long-term forecasting of returns from stocks.
  • The Fed Model helps explain why P/E varies over time, especially when adjusted for stock and bond relative volatility (risk), but it is not a useful predictor of long-term future returns from stocks.
  • A risk-adjusted (in other words, complicated) application of the Fed Model can identify short-term opportunities for returns from stocks based on fluctuations between stock and bond yields.

In summary, the Fed Model is inferior to fundamental valuation in predicting long-term stock returns, but it may have some tactical value.

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