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The Fed Model

The Fed Model

In yesterday’s blog post, I gave you a technical picture of the market and how it seems to have turned a corner in the eyes of investors.

Today, I thought I’d give you a look at another series of charts I follow that helps me know when stocks are undervalued compared to bonds. The series of charts above represent what Edward Yardeni has coined as the Fed Model – they are provided courtesy of Portfolio 123 but I’ve annotated them so you can more readily see what I see.

The Fed Model originated from the work of Alan Greenspan – in 1997 he stated that changes in the S&P 500 Earnings Yield have been inversely related to changes in treasury yields. You can see that exact correlation in the bottom of the three graphs above – you can see that I’ve noted that the spread between the two is wider than at any point in the past decade.

To understand what this ratio is telling us, you have to understand what the S&P 500 Earnings Yield means: its pretty simple actually – its the earnings of the S&P 500 divided by the current index value – or you can think of it as the mirror image of the P/E ratio on the S&P 500. This ratio is giving you the percentage of each dollar invested in the S&P 500 that is being earned by the companies that comprise that index.

The theory goes that treasury notes are a risk free investment and that investors in equity securities should receive a higher total yield than treasuries for the extra risk assumed. That total yield is represented by the net earnings of the companies in the index and NOT just the dividends – the net earnings represent the composite of the dividends they company pays and the retained earnings that are held by the company as capital to support future growth. The difference between the risk-free treasury yield and the earnings yield on equities for assuming stock market risk is called the Risk Premium.

The wider the spread between the lower treasury yield and the higher earnings yield, according to the theory, the greater the potential return on your equity investments in coming months.

Conversely, when the spread narrows or even crosses, you know that stocks are likely overvalued on an earnings basis – long-time clients will remember that this was one of the primary indicators we used to reduce stock market exposure prior to the NASDAQ crash at the beginning of the past decade. When earnings aren’t there and risk free yields are high enough, investors make the rational decision to move money out of stocks because they aren’t being paid enough to assume the risk.

If you look at the middle chart above, you can see that we have a decade high in corporate earnings for the S&P 500. Putting that number in the numerator of our ratio logically will give us a higher earnings yield than recent years, but you also have to look at the denominator. In this case, we have all lived through the 2008 stock market crash and we know that we are only about 2/3 of the way recovered from that crash as you can see in the chart below:


The combination of a decade high in earnings and an index that is 33% below its peak is what gives us such a high earnings yield.

The question you should have is whether this actually has translated into higher stock prices when there is a relationship like we see now.

Take a look at the top graph above – this shows the S&P 500 Index price (the blue line) compared to the difference between the Earnings Yield and the Treasury Yield (the black line called the Risk Premium).

– (1) When the Risk Premium is at a high (high earnings yield and low treasury yield), the stock market is generally due for a rally because investors are being paid to assume the risk of being in the stock market, and

– (2) When the Risk Premium is at a low (low earnings yield and high treasury yield), the stock market is generally due for a correction because investors are not being paid enough for the risk they are assuming in the stock market.

I’ve circled two instances so you can see this relationship – the first set is from the March 2009 post-crash lows – and the second set is where we are currently.

This indicator tells me that investors are at the point where they will look at the comparative value between stocks and bonds, and make a rational decision to allocate their investment dollars to stocks given their superior earnings instead of bonds that are paying them less than the rate of inflation.

Am I expecting stock prices to hit the highway like a battering ram and skyrocket higher? Not likely, but I definitely believe – absent some major catastrophe in Europe – that we can see six to seven percent upside based upon yesterday’s technical study. After we get that under our belt, we will see what the market and corporate earnings are telling us – remember, invest what you see, not what you believe.

Have a great weekend! I’m headed to the ILL V Nebraska game shortly and hope to see many of you there!

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