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.

RELATED TERMS
  1. Predictive Modeling

    Predictive modeling is the process of using known results to ...
  2. Financial Modeling

    The process by which a firm constructs a financial representation ...
  3. Black's Model

    Black's Model is a variation of the popular Black-Scholes options ...
  4. Multi-Factor Model

    A multi-factor model uses many factors in its computations to ...
  5. Six Forces Model

    The six forces model is a strategic business tool that helps ...
  6. Default Model

    Default model is constructed by financial institutions to determine ...
Related Articles
  1. Insights

    The Fed Model And Stock Valuation: What It Does And Does Not Tell Us

    Learn about this popular stock market valuation model and how accurate it has been over the years.
  2. Insights

    What Does the Federal Reserve Do?

    What is the Federal Reserve System and how does it affect interest rates, inflation and the market?
  3. Investing

    Understanding The Federal Reserve Balance Sheet

    We are all connected to the Fed's balance sheet, and the currency notes that we hold are its liabilities.
  4. Investing

    Financial Models You Can Create With Excel

    The relatively modest amount of time it takes to build these models can pay for itself by leading you to better investment decisions.
  5. Insights

    Fed Hikes 25 Basis Points, Signals Two More Hikes in 2017

    As expected the Fed raised the fed funds rate by 25 basis points.
  6. Investing

    How to choose the best stock valuation method

    There are many valuation methods available to investors, each with unique characteristics. Here, we'll explore the most common valuation methods – and when to use them.
  7. Tech

    Predictive Analytics Drives Return for Investors

    A new industry of predictive analysis has developed to make sense of big data and give investors real-time buy and sell recommendations based on the patterns forming in the data long before traditional ...
  8. Investing

    Why Isn't the Bond Market Selling Off?

    From quantitative easing to quantitative tightening. Why aren't bond prices moving lower?
  9. Investing

    How The Fed May Kill The 2018 Stock Rally

    Hawk Attack: A more hawkish Fed may spell trouble for stocks
  10. Investing

    How The Federal Reserve Fights Recession

    Discover the steps that the Federal Reserve has taken to help save the economy.
RELATED FAQS
  1. Are perfect competition models in economics useful?

    Take a look at some of the arguments made by the proponents and critics of the theory of perfect competition in contemporary ... Read Answer >>
  2. What are some examples of different corporate governance systems across the world?

    Read about the three major types of corporate governance systems: the Japanese model, the Anglo-Saxon model and the continental ... Read Answer >>
  3. What are the advantages and disadvantages of the Gordon Growth Model?

    Understand the advantages and disadvantages of using the Gordon Growth Model to value a company's publicly traded stock. ... Read Answer >>
Hot Definitions
  1. Investment Advisor

    An investment advisor is any person or group that makes investment recommendations or conducts securities analysis in return ...
  2. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  3. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  4. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  5. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  6. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
Trading Center