Fed model
[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.
[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.
Yardeni quoted a paragraph and graphic (see image opposite), from the Fed's July 1997 Monetary Policy Report to the Congress, which implied Greenspan was using the model to express concerns about market overvaluation, with Yardeni saying: "He [Greenspan] probably instructed his staff to devise a stock market valuation model to help him evaluate the extent of this irrational exuberance":[24][25] …changes in this ratio [P/E of the S&P 500 index] have often been inversely related to changes in the long-term Treasury yields, but this year's stock price gains were not matched by a significant net decline in interest rates.
[10] The "Fed model" was never officially endorsed as a metric by the Fed, but Greenspan referenced the relationship several times including in his 2007 memoirs, saying: "The decline of real (inflation-adjusted) long-term interest rates that has occurred in the last two decades has been associated with rising price-to-earnings ratios for stocks, real estate, and in fact all income-earnings assets".
[20] In December 2020, Fed Chair Jerome Powell, invoked the "Fed Model" to justify high stock market price-earnings ratios (then approaching levels of the Dot-com bubble, in a period called the everything bubble),[21] saying: "If you look at P/Es they're historically high, but in a world where the risk-free rate is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you'd look at".
It's not too often that a Fed chair engages in that exercise.In February 2021, The Wall Street Journal noted that stock valuations were in a bubble on almost every metric except for that of the Fed Model (i.e. 10-year Treasury yields), which the WSJ felt Powell was using as a guide on how far his policy of extreme stimulus/monetary looseness could be used to push stock prices higher.
the risk-free rate (10-year nominal treasury notes), and RP the equity risk premium; then making the following assumptions:[10] one gets the Fed model: E/P=
[8] In 2017, Stuart Kirk, head of Deutsche Bank's DWS Global Research Institute and a former editor of the Financial Times Lex column, wrote of DWS's analysis of the long-term data: "In other words no historical relationship between bond yields and dividend yields.
[37] A test of whether the Fed model is an equity valuation theory with descriptive validity is that it should be able to identify over-valued and under-valued assets.
Davis found that "it was basically worthless", and that it's r-squared metric of 0.5%, compared poorly that those of other ratios, including P/E (56.3%), P/Sales (67.2%), and Households' equity allocation as a % of Total Financial Assets (88.4%).
[12] In June 2020, finance author Mark Hulbert, ran a statistical test from 1871 to 2020 of the Fed Model's ability to forecast the stock market's inflation-adjusted real return over subsequent 1, 5, and 10-year periods, and found that adding long-term Treasury yields, per the Fed model, materially reduced the predictive power of just using the earnings yield (E/P) on its own.
[2][5] Economist Richard Koo noted that in post-1990 Japan, the bursting of an asset bubble led to a balance sheet recession that compressed Japanese long-term government bond yields to almost zero.
However, the forward earnings yield on the Nikkei rose steadily for several decades post the 1990 collapse, only falling during periods of deliberate intervention by the Bank of Japan (BOI), and only really gaining traction post-2013 when the BOJ began to directly purchase Japanese equity ETFs in large quantities.
[14] Koo explained that in Japan the rise in the earnings yield was due to a collapse in long-term growth prospects for Japanese equities (per Gordon's growth model, above), which was compounded by the dramatic rise in the value of Japanese government bonds (from the 10-year yield falling to almost zero), which "crowded-out" equities in the allocation of investor capital.
Under this theory, it is the Wall Street investment banks who drive the Fed model relationship via the allocation of their repo trades into the markets, which when done on a continuous and steady basis, can also create the investor habit observed by Bekaerk and Engstrom (analysts at the Wall Street investment banks are noted by academics,[10] and financial authors,[15] as some of the strongest supporters of the rationale for the Fed model relationship).
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 ]
