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Fed Model Indicates Stock Market Warning: What Investors Must Know Now

Emilia Wright | November 19, 2024

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This Fed-Based Market Signal is Flashing a Warning for the First Time in Over a Decade: What You Need to Know

Understanding the Fed Model

The financial markets are abuzz with discussions around a particular model known as the “Fed Model.” This model compares the stock market’s earnings yield—essentially the inverse of the price-to-earnings (P/E) ratio—with the yield on 10-year Treasury bonds. Traditionally, the Fed Model suggests that if the earnings yield is higher than the 10-year Treasury yield, conditions are favorable for stocks. Conversely, if the earnings yield is lower, the outlook for equities tends to be less optimistic.

Currently, a concerning divergence has emerged. The earnings yield of the S&P 500, based on trailing 12-month earnings per share, stands at **3.90%**, while the 10-year Treasury yield is at **4.46%**—a significant difference of over half a percentage point. This shift has alarmed some market watchers, as the last substantial decline into negative territory occurred during the financial crisis of 2008-09.

A Historical Perspective on the Fed Model

While the Fed Model has drawn attention due to its current negative stance, it is essential to evaluate its historical performance. A thorough analysis of the model, tracing back to **1871** and supported by data from Yale University’s Robert Shiller, reveals a disheartening truth: the predictive ability of the Fed Model is lacking.

To quantify this, an r-squared statistic was utilized to gauge how effectively the earnings yield and the Fed Model could predict stock market returns over various periods. The findings were revealing:

  • When forecasting the S&P 500’s 12-month return:
    • **Earnings Yield R-squared**: 2.8%
    • **Fed Model R-squared**: 1.2%
  • When forecasting the S&P 500’s 5-year return:
    • **Earnings Yield R-squared**: 11.3%
    • **Fed Model R-squared**: 3.9%
  • When forecasting the S&P 500’s 10-year return:
    • **Earnings Yield R-squared**: 28.1%
    • **Fed Model R-squared**: 11.4%

This data suggests that the earnings yield alone has a significantly greater predictive power regarding stock market performance than when it is combined with the 10-year Treasury yield in the Fed Model.

Why the Fed Model Falls Short

It may come as a surprise that the Fed Model does not outperform the earnings yield, leading to the question: why? The discrepancy arises from comparing two different types of yields—the stock market’s earnings yield, which reflects real economic conditions, against the nominal yield of Treasury bonds that does not adjust for inflation.

As Cliff Asness, founder of AQR Capital Management, articulated in his influential paper, **”Fight The Fed Model,”** the model could be insightful at first glance but is ultimately misleading. His findings suggest a common misconception within Wall Street strategy, underscoring the confusion between real yields and nominal yields, a phenomenon known as “money illusion.”

In Asness’s words, “The Fed model has the appearance but not the reality of common sense. The allure of this common sense has captivated numerous strategists and analysts, yet it is fundamentally misguided.”

The Bigger Picture: Is the Stock Market Overvalued?

Although the current status of the Fed Model may not warrant additional worries about the stock market, it does not imply that investors should disregard other potential risks. Concerns about stock valuations are still prevalent and could stem from a myriad of factors beyond the simple comparison of yields.

As the market dances in response to various economic indicators and trends, it is vital for investors to remain educated and cautious. Those who are banking on the Fed Model’s warning may find comfort in its historical context, but they should take care not to let it overshadow a broader analysis of market conditions.

Conclusion

In summary, while the Fed Model is currently sending a negative signal regarding market conditions—one not seen in over a decade—its historical performance does not necessitate undue concern. Investors should recognize its limitations and remain focused on comprehensive strategies that take into account a wide array of market factors. Stay informed and adaptable in these uncertain times.