What is the Fed Model
The Fed model is a tool for determining whether the U.S. stock market is fairly-valued at a given time. The model is based on an equation that compares the earnings yield of the S&P 500 with the yield on 10-year U.S. Treasury bonds.
Economist Ed Yardeni created the Fed model. He gave it this name saying it was the "Fed's stock valuation model, though no one at the Fed ever officially endorsed it."
BREAKING DOWN Fed Model
The Fed model dictates that if the S&P’s earnings yield is higher than the U.S. 10-year bonds yield, the market is “bullish.” A bullish market assumes stock prices are going to rise and a good time to buy shares.
If the earnings yield dips below the yield of the 10-year bond, the market is considered “bearish.” A bearish market assumes stock prices will decline. The widely used and accepted model, popularized by Yardeni, still has many investing experts questioning its utility in recent years.
The Fed model has lost some of its reputations as a dependable predictor of markets since it failed to predict the Great Recession. Leading up to the financial crisis, the Fed model had assessed the market as being bullish since 2003. This gave investors optimism in the markets, encouraging them to buy stocks. The Fed model still declared a bullish market in October 2007, the cusp of the Great Recession.
Investors who followed the implicit advice of the Fed model purchased stocks assuming that their prices would rise. Instead, they saw them drop sharply and continue to lag in value through the following, long recession.
Alternatives to the Fed Model
After failing to predict the Great Recession, the Fed model also was unable to predict the euro crisis and the junk bond bust of 2015. Despite these slips, the model is still widely used as a predictive tool for investors. However, other valuation models also exist some with better-proven track records in predicting market direction.
These other valuation models include looking at the price-earnings (P/E) ratio alone, the price/sales ratio and looking at household equity as a percentage of total financial assets. Economist Ned Davis of Ned Davis Research looked at the predictive history of each of these models, including the Fed model, and found that among them, the Fed Model proved to be the least accurate in predicting bear and bull markets.