For the First Time in Over a Decade, This Fed-based Market Signal Flashes a Warning. Here’s Why It Matters

The "Fed model" isn’t about to derail the stock market, despite what some might claim. This widely discussed market-timing model compares the stock market’s earnings yield (the inverse of its price-to-earnings, or P/E, ratio) with the yield on the 10-year U.S. Treasury bond. Advocates of the Fed model suggest equities are attractive when the earnings yield exceeds the 10-year yield and unattractive when it falls below.

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Currently, the model signals unfavorable conditions for equities. The S&P 500’s earnings yield, based on trailing 12-month earnings per share, stands at 3.90%, while the 10-year Treasury yield is higher at 4.46%, a difference of over half a percentage point. The last time this disparity reached such negative territory was during the 2008-09 financial crisis, which might seem alarming. However, the model’s historical track record suggests its value in forecasting stock market performance is questionable at best.

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To evaluate the Fed model's reliability, I analyzed data going back to 1871, using statistics from Yale University economist Robert Shiller. Specifically, I examined how well the earnings yield and the Fed model predicted the stock market’s inflation-adjusted total returns over subsequent one-, five-, and ten-year periods. The results reveal that the earnings yield alone outperforms the Fed model in all cases.

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This is captured by the r-squared statistic, which measures how well one data series explains or predicts another. Across all time frames, the earnings yield had greater predictive power than the Fed model, which subtracts the 10-year Treasury yield from the earnings yield.

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Why the Fed Model Falls Short

The limitations of the Fed model lie in its flawed comparison of two fundamentally different metrics. The stock market’s earnings yield is a real yield because corporate earnings tend to grow faster during periods of higher inflation. By contrast, the 10-year Treasury yield is a nominal yield, which does not account for inflation. Comparing a real yield with a nominal one results in what financial experts call a "money illusion." Consequently, the Fed model’s conclusions are inherently unreliable.

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This fundamental flaw was thoroughly dissected two decades ago by Cliff Asness, the founder of AQR Capital Management. In his paper, Fight the Fed Model, published in the Journal of Portfolio Management, Asness provided both theoretical and empirical evidence against the model.

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He argued that the Fed model gives the impression of being rooted in common sense, but this is largely misleading. Asness wrote, “The Fed model has the appearance but not the reality of common sense. The lure of this common sense has captured many a Wall Street strategist and media pundit. However, this common sense is largely misguided, most likely because of a confusion of real and nominal (money illusion).”

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Broader Implications

It’s important to note that the shortcomings of the Fed model do not imply the stock market is undervalued. Investors may still have legitimate concerns about the outlook for equities in the months and years ahead. However, those concerns should not be based on the Fed model's current negative signal. Its inability to reliably forecast stock market performance renders it an ineffective tool for guiding investment decisions.

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The model’s failure also challenges the intuitive notion that stocks should perform better when interest rates are low compared to when they are high. While this idea seems logical, historical data does not support it. The reality is more complex, influenced by factors such as inflation expectations, corporate earnings growth, and broader economic conditions.

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Rather than relying on flawed models like the Fed model, investors should focus on more robust indicators, such as corporate earnings, valuation metrics, and macroeconomic trends. These factors provide a clearer picture of the market’s health and potential. While the relationship between interest rates and stock valuations remains an important consideration, it should be viewed within the broader context of real economic growth and inflation dynamics.

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Additionally, investors should resist the temptation to overreact to short-term signals or alarmist interpretations of market models. Building a diversified portfolio with a focus on long-term goals remains the most reliable strategy for navigating market uncertainty. This approach allows investors to benefit from overall economic growth while mitigating risks associated with market fluctuations.

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Conclusion

In summary, the Fed model’s current unfavorable reading should not heighten concerns about the stock market. Its flawed methodology—comparing real and nominal yields—renders it an unreliable tool for assessing equity valuations or predicting future returns. While the model has garnered significant attention over the years, its practical value remains limited. Investors would be better served by focusing on more reliable indicators and maintaining a disciplined, long-term investment strategy.

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