The "FED Model" theory of equity valuation

The "FED model" is a popular yardstick for judging whether the stock market is fairly valued. This term was coined by Prudential Securities strategist Ed Yardeni after a Fed report to Congress in July 1997 suggested the bank was following it.

The FED model compares the yield of the 10-yr govt bond to the "earnings yield" of the S&P 500. The "earnings yield" is defined as the inverse of the forward P/E ratio of the S&P 500. As of the market close today the S&P 500 is trading at 1230.96 and the projected earnings for 2006 of the components of the index are $78.30. The forward P/E ratio for the S&P 500 is therefore about 15.72 (1230.96/$78.30). The inverse of the forward P/E ratio is E/P, known as the earnings yield. In this case, (1/15.72) is .0636, or 6.36%. As of market close today, the yield on the 10-yr govt. bond was 4.564%.

In theory, the yield on the 10-yr bond is equivalent to the different between the earnings yield and the risk premium (i.e., because stocks are riskier than bonds the earnings yield should ordinarily be less than the yield on the 10-yr bond). In this case, 4.564% = 6.36% - Rp (risk premium). In this case, Rp is 1.796%. Between 1994 and 2003, the average risk premium was 0.11%. Therefore, the current Rp of 1.796% is a very bullish sign and signals that it's probably a good time to buy.

During the stock market bubble, the risk premium was around -2% or worse - i.e., investors bid up stocks to great highs because stocks were actually viewed as being less risky than bonds. Today, on the other hand, investors are completely shunning stocks and invest their money in bonds instead.

CAVEATS

Although the FED model is useful, it does have its flaws. For example, the earnings yield is based on projected earnings, and it's always possible that the economy could go south and those projections will not be met. Moreover, this model only addresses the relative (not absolute) valuations of stocks and bonds. Stocks do not necessarily have to rise for Rp to decrease; instead, stocks could stagnate while bonds decrease in value.