For the first time in over a decade, a Fed-based market signal is flashing a warning. But before you start preparing for a market crash, let’s break down what the Fed Model is, why it’s important, and why it doesn’t necessarily spell disaster for the stock market.
The Fed model compares the stock market’s earnings yield (which is the inverse of the price-to-earnings, or P/E, ratio) with the 10-year Treasury yield. For many market analysts, this has been a go-to tool for gauging whether stocks are undervalued or overvalued compared to government bonds.
So, what’s the big deal now?
The S&P 500’s earnings yield sits at 3.90%, while the 10-year yield has climbed to 4.46%—more than half a percentage point higher. In other words, the earnings yield is now lower than the 10-year Treasury yield. This marks a significant shift, as the last time we saw a similar negative divergence was during the 2008-09 financial crisis.
While this may sound alarming, it’s essential to understand that the Fed model isn’t as predictive of market performance as it seems. In fact, its long-term track record is surprisingly weak, even when used as a tool for market forecasting. Let’s dive into why this warning sign might not be as ominous as it appears.
What Is the Fed Model, and Why Does It Matter?
Before we get into why the Fed model doesn’t offer reliable predictions, let’s understand how it works.
The Fed model compares the earnings yield of the stock market (which is simply earnings per share divided by the stock price) to the 10-year Treasury yield. The idea is simple:
- When the earnings yield is higher than the Treasury yield, stocks look like a better investment compared to bonds.
- When the earnings yield is lower than the Treasury yield, stocks seem less attractive.
The model gained traction because it’s grounded in the idea that stocks and bonds are competing assets—with stocks offering potential for growth, and bonds providing steady, risk-free returns.
So why does the model matter now?
With the S&P 500’s earnings yield at 3.90%, and the 10-year Treasury yield sitting higher at 4.46%, the market signal from the Fed model is flashing a warning. Historically, a significant drop in the earnings yield below the 10-year Treasury yield has been associated with market weakness. However, as we’ll see, this signal doesn’t always lead to disaster.
A Closer Look at the Fed Model’s Track Record
I know what you’re thinking: “If this indicator has been around for so long, surely it’s a reliable predictor of future market returns, right?” Unfortunately, the Fed model doesn’t have the predictive power many think it does.
Let’s take a deeper look at the performance of the Fed model when predicting the S&P 500’s returns over different time horizons. I analysed data back to 1871 using data from Yale University’s Robert Shiller.
R-Squared: The Key Measure
The r-squared statistic is a measure of how well one data series explains or predicts another. A higher r-squared means a better predictive power.
Here’s what I found:
| Time Horizon | R-Squared (Earnings Yield Only) | R-Squared (Fed Model) |
|---|---|---|
| 1-year S&P 500 Return | 2.8% | 1.2% |
| 5-year S&P 500 Return | 11.3% | 3.9% |
| 10-year S&P 500 Return | 28.1% | 11.4% |
As you can see, the earnings yield alone has a much stronger predictive power for the stock market’s returns compared to when it’s paired with the Fed model (which also includes the 10-year Treasury yield). The Fed model doesn’t seem to improve much upon the earnings yield when forecasting the S&P 500’s returns.
Why Doesn’t the Fed Model Work as Well as Expected?
You may be wondering: why doesn’t the Fed model perform better, considering the logic behind it seems sound.
The answer lies in the fact that the Fed model is comparing apples to oranges—or, more specifically, real vs. nominal yields.
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The Stock Market’s Earnings Yield is a real yield. Historically, corporate earnings have tended to grow faster during inflationary periods, which makes the earnings yield more reflective of real economic conditions.
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The Treasury Yield, on the other hand, is a nominal yield. This yield doesn’t take inflation into account; it’s simply the return you get from holding a government bond for 10 years.
Thus, comparing a real yield (earnings yield) with a nominal yield (Treasury yield) creates a distorted picture. According to Cliff Asness, founder of AQR Capital Management, this discrepancy is what causes the Fed model to “fail.” In his seminal paper, “Fight the Fed Model”, Asness explains that the Fed model has “the appearance but not the reality of common sense.” He argues that comparing real and nominal yields leads to misguided conclusions and is ultimately a poor way to forecast market returns.
Does This Mean the Stock Market is Safe?
Just because the Fed model is flashing a negative signal doesn’t mean we should ignore the stock market’s potential risks. The model’s flaws don’t negate the possibility that the market could be overvalued or face other macroeconomic pressures.
There are plenty of other legitimate reasons to be cautious about stocks, such as inflation, global instability, and economic slowdowns. But based on historical data, relying on the Fed model alone to guide investment decisions is not the best approach.
Conclusion: The Fed Model Is Just One Piece of the Puzzle
The Fed model may be flashing a warning, but it’s important to recognise its limitations. While it’s easy to be spooked by its current signal, history shows that the Fed model doesn’t have the predictive power many assume.
So, don’t panic—use the model as one tool in your toolbox, but don’t make it the cornerstone of your market strategy. Focus on broader economic factors, corporate earnings growth, and long-term investment goals.
The stock market is complex, and the Fed model’s warning is just one of many signals to consider.
