What Is the Fed Model?
The Fed model is a market timing tool for determining whether the U.S. stock market is fairly-valued. 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. The model was never officially endorsed by the Federal Reserve and was originally called the Fed's Stock Valuation Model.
The Fed model today dictates that if the S&P’s earnings yield is higher than the U.S. 10-year bonds yield, the market is “bullish"; if the earnings yield dips below the yield of the 10-year bond, the market is considered “bearish.”
Understanding the Fed Model
Economist Ed Yardeni is credited with developing the Fed model in its current form in 1999, but a graph showing the relationship between long-term Treasury bond yields and earnings yields from 1982 to 1997 was published two years earlier in the Fed's Humphrey-Hawkins Report.
The Fed model today dictates that if the S&P’s earnings yield is higher than the U.S. 10-year bonds yield, the market is “bullish.” That is, the total earnings of the companies within the S&P 500 are relatively high compared to returns from holding 10-year government bonds. A bullish market assumes stock prices are going to rise and therefore now is a good time to buy shares.
If the earnings yield dips below the yield of the 10-year bond, the market is considered “bearish.” Companies are not producing relatively high earnings compared to the yield on 10-year bond yields. The Fed model predicts a bearish market and suggests that stock prices will decline.
The Fed model does not have a reputation 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 Fed model followers optimism in the markets, encouraging them to buy stocks. The 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 lose value through the following, long recession.
- The Fed Model is a market-timing tool based on a formula that compares earnings yields and Treasury bond yields.
- When yields are higher in the bond market compared to earnings yields, the Fed model says the outlook is bearish and it is time to sell stocks.
- If earnings yields are greater than bond yields, the Fed model says the market is bullish, and it is a good time to buy stocks.
- The Fed model's track record is not compelling—it remained bullish before several important market downturns, including the 2008 financial crisis.
Alternatives to the Fed Model
After failing to predict the Great Recession, the Fed model also failed to predict the euro crisis and the junk bond bust of 2015. Despite these slips, some investors still rely on the model as a predictive tool.
Other market timing and valuation models—some with better-proven track records in predicting market direction—also exist. These valuation models examine other market data: price-to-earnings ratios, the price-to-sales ratios, or household equity as a percentage of total financial assets.
Notably, economist Ned Davis of Ned Davis Research looked at the predictive history of each of these models, including the Fed model, and found that the Fed Model proved to be the least accurate in predicting bear and bull markets.