The Fed Model and Equity-Bond Valuation

The Fed model compares the S&P 500's forward earnings yield (forward earnings per share divided by index price — the inverse of the forward price-to-earnings ratio) directly against the yield on the 10-year Treasury bond. When the earnings yield sits above the bond yield, the model reads equities as cheap relative to bonds; when it sits below, equities look expensive relative to bonds, on the reasoning that both are competing claims on an investor's capital and their yields should roughly track each other. It gets its name from a chart in a 1997 Federal Reserve report to Congress that happened to note this relationship, not from any actual Fed policy or endorsement.

The model has real weaknesses that limit its use as anything more than a rough gut check: earnings yield reflects real (inflation-adjusted) cash flows while a nominal bond yield does not, so the comparison implicitly assumes a specific, often wrong, relationship between inflation and equity earnings growth, and it ignores that equity cash flows grow over time while a bond's coupon does not — both distortions that can make the model look badly wrong for years even if stocks and bonds are each fairly priced within their own asset class.

With a forward P/E of 20 (earnings yield of $1/20 = 5\%$) against a 10-year Treasury yield of 4%, the Fed model reads a 1 percentage point gap in equities' favor — a rough signal that stocks screen cheap relative to bonds by this measure, though not a claim about either being cheap or expensive in absolute terms.