There is unlikely any chance that the Fed model is going to upset the stock market, despite some claims to the contrary. The frequent mention of the Fed model for timing the market compares the earrings of the stock market yield with the yield on the 10-year U.S. Treasury bond.
Those who support the Fed model propose that the qualities have not become appealing when the earnings yield has surpassed the 10-year yield and less so when it falls below it.
Right now, the model indicates poor conditions for equities, the earnings yield of the S&P 500 is at 3.90% as calculated from the past 12 months’s earnings per share. Whereas the yield on the 10-year Treasury is higher at 4.46% creating a gap of over half of a percentage point.
The last time such type of negative disparity was noticed was during the financial crisis of 2008-2009, which may sound concerning. However, the history of this model states that it can predict market outcomes is questionable. The reliability of the Fed model could be assessed by having a look at the statistics from economist Robert Shiller from 1871. The findings indicate that the earnings yield by itself outperformed the Fed model in every case.
The shortcomings of the Fed model stem from its inappropriate comparison of two metrics that are fundamentally different. The earnings yield of the stock market signifies a real yield as it is visible that corporate earnings increase at a faster pace during inflation.
In contrast to this, the 10-year Treasury yield remains a nominal yield that is not a factor in inflation and when it comes to comparing a real yield to a nominal one, it leads to a ‘money illusion’ as termed by financial analysts.
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