The "Fed model" or "Fed Stock Valuation Model" (FSVM), is a disputed
theory
A theory is a rational type of abstract thinking about a phenomenon, or the results of such thinking. The process of contemplative and rational thinking is often associated with such processes as observational study or research. Theories may ...
of
equity valuation that compares the
stock market
A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include ''securities'' listed on a public stock exchange, ...
's forward
earnings yield to the
nominal yield The coupon rate (nominal rate, or nominal yield) of a fixed income security is the interest rate that the issuer agrees to pay to the security holder each year, expressed as a percentage of the security's principal amount or par value. The coupon r ...
on long-term
government bonds
A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity dat ...
, 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.
[
The relationship has only held in the United States, and only for two main periods: 1921 to 1928 and from 1987 to 2000.][ It has been shown to be flawed on a theoretical basis,] fails to hold in long-term analysis of data (both in the United States, and international markets),[ and has poor predictive power for future returns on a 1, 5 and 10-year basis.][ The relationship can breakdown completely at very low real yields (from natural forces, or where yields are artificially suppressed by ]quantitative easing
Quantitative easing (QE) is a monetary policy action whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary pol ...
);[ in such circumstances, without additional central bank support for the stock market (e.g. use of the ]Greenspan put
The Greenspan put was a monetary policy response to financial crises that Alan Greenspan, former chair of the Federal Reserve, exercised beginning with the crash of 1987. Successful in addressing various crises, it became controversial as it l ...
by the Fed in 2020, or the Bank of Japan
The is the central bank of Japan. Nussbaum, Louis Frédéric. (2005). "Nihon Ginkō" in The bank is often called for short. It has its headquarters in Chūō, Tokyo.
History
Like most modern Japanese institutions, the Bank of Japan was foun ...
's purchase of equities post-2013), the relationship collapses.[
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.][ 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
Long-Term Capital Management L.P. (LTCM) was a highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.
LTCM was founded in ...
-type vehicles being a noted example[).][
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
Alan Greenspan (born March 6, 1926) is an American economist who served as the 13th chairman of the Federal Reserve from 1987 to 2006. He works as a private adviser and provides consulting for firms through his company, Greenspan Associates LLC. ...
on equity valuations.[ In 2014, Yardeni noted that the predictive power of the Fed model stopped working almost as soon as he noted the relationship.][ The term was never formally endorsed by the Fed,][ however, Greenspan made further references to the relationship.][ In December 2020, the Fed Chair ]Jerome Powell
Jerome Hayden "Jay" Powell (born February 4, 1953) is an American attorney and investment banker who has served as the 16th chair of the Federal Reserve since 2018.
After earning a degree in politics from Princeton University in 1975 and a ...
, invoked the relationship to justify stock market valuations that were approaching levels not seen since the 1999–2000 Dot-com bubble
The dot-com bubble (dot-com boom, tech bubble, or the Internet bubble) was a stock market bubble in the late 1990s, a period of massive growth in the use and adoption of the Internet.
Between 1995 and its peak in March 2000, the Nasdaq Comp ...
or the 1929 market bubble,[ due to exceptional monetary looseness by the Fed.][
]
Formula
The Fed model compares the one-year forward-looking I/B/E/S earnings yield on the S&P 500 Index
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
to the nominal 10-year US Treasury note yield, .[
:, means the stock market, in aggregate, is fairly valued.]
: