Bears Are Betting on This Earnings-Based Market Predictor — But It Rarely Delivers
No, the “Fed model” isn’t poised to sink the stock market anytime soon.
The model, well-known among market enthusiasts, compares the stock market’s earnings yield (the inverse of the P/E ratio) to the 10-year Treasury yield. According to its adherents, equities are attractive when the earnings yield exceeds the Treasury yield, and risky when the reverse is true.
Currently, the S&P 500’s earnings yield (based on trailing 12-month EPS) stands at 3.90%, while the 10-year Treasury yield is at 4.46%, creating a negative spread. The last time this gap was significantly negative was during the 2008-09 financial crisis — an ominous comparison for bears.
But historical data suggests the Fed model’s predictive power is weak at best.
A Flawed Predictor
Using data from Yale professor Robert Shiller, I analyzed the Fed model’s performance back to 1871. By comparing the model to simpler metrics like the earnings yield, I evaluated their ability to predict inflation-adjusted total stock market returns over one-, five-, and ten-year periods.
The results? The earnings yield consistently outperformed the Fed model. Adding the 10-year Treasury yield to the equation weakened the model’s predictive power rather than enhancing it.
Why the Fed Model Fails
The fundamental flaw lies in comparing two mismatched metrics: the stock market’s earnings yield, which is real (adjusted for inflation), and the Treasury yield, which is nominal (not inflation-adjusted). This mismatch renders the model unreliable.
Cliff Asness, founder of AQR Capital Management, dissected this issue in his seminal paper “Fight the Fed Model,” published two decades ago. He concluded:
“The Fed model has the appearance but not the reality of common sense… largely because of a confusion of real and nominal (money illusion).”
Don’t Bank on the Fed Model
This critique doesn’t imply the stock market is immune to risks. There may be valid concerns about valuations or macroeconomic headwinds. But the Fed model’s negative signal isn’t one of them. History shows it’s more mirage than market compass — a shaky foundation for bearish bets