Robert Shiller's plot of the S&P 500 price–earnings ratio (P/E) versus long-term Treasury yields (1871–2012), from Irrational Exuberance.[1] The P/E ratio is the inverse of the E/P ratio, and from 1921 to 1928 and 1987 to 2000, supports the Fed model (i.e. P/E ratio moves inversely to the treasury yield), however, for all other periods, the relationship of the Fed model fails;[2][3] even up to 2019.[4]
The "Fed model", or "Fed Stock Valuation Model" (FSVM), is a disputed theory of equity valuation that compares the stock market's forward earnings yield to the nominal yield on long-term government bonds, and that the stock market – as a whole – is fairly valued, when the one-year forward-looking I/B/E/S earnings yield equals the 10-year nominal Treasury yield; deviations suggest over-or-under valuation.[5][6][7][8][9]
The relationship has only held in the United States, and only for two main periods: 1921 to 1928 and from 1987 to 2000.[2][4][6] It has been shown to be flawed on a theoretical basis,[8][10] fails to hold in long-term analysis of data (both in the United States, and international markets),[6][8] and has poor predictive power for future returns on a 1, 5 and 10-year basis.[8][11][12] The relationship can breakdown completely at very low real yields (from natural forces, or where yields are artificially suppressed by quantitative easing);[13] in such circumstances, without additional central bank support for the stock market (e.g. use of the Greenspan put by the Fed in 2020, or the Bank of Japan's purchase of equities post-2013), the relationship collapses.[2][14]
The Fed model is used by Wall Street sales desks as it almost always gives a "buy signal", and has rarely signaled stocks are overvalued.[15] Some academics say the relationship, when it appears, is driven by the allocation of the Fed's balance sheet to Wall Street banks via repurchase agreements as part of Fed put stimulus (i.e. the relationship reflects the investment strategy these banks follow using borrowed Fed funds when the Fed is stimulating asset prices, e.g. Wall Street banks lending to Long-Term Capital Management-type vehicles being a noted example[16]).[17][18][19]
The term was coined in 1997–99 by Deutsche Bank analyst Dr. Edward Yardeni commenting on a report on the July 1997 Humphrey-Hawkins testimony by the then-Fed Chair, Alan Greenspan on equity valuations.[2] In 2014, Yardeni noted that the predictive power of the Fed model stopped working almost as soon as he noted the relationship.[3] The term was never formally endorsed by the Fed,[15] however, Greenspan made further references to the relationship.[20] In December 2020, the Fed Chair Jerome Powell, invoked the relationship to justify stock market valuations that were approaching levels not seen since the 1999–2000 Dot-com bubble or the 1929 market bubble,[21] due to exceptional monetary looseness by the Fed.[22][23]
^Shiller, Robert (2005). Irrational Exuberance (2d ed.). Princeton University Press. ISBN 0-691-12335-7.
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