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Revisiting the Fed Model

by Stuart Chaussee

Remember the Fed Model? If your memory needs refreshing, here's a quick review. For years, there's been a strong correlation between the earnings yield for the S&P 500 (inverse of the forward price-to-earnings ratio) and the yield on the 10-year Treasury note. The implication is that stocks are fairly valued when the two are equal. When the earnings yield for stocks is greater than the Treasury yield, stocks are undervalued. When the Treasury's yield is higher, stocks are overvalued relative to bonds. The last time I read a detailed write-up about the Fed Model was in 2001, right after the markets reopened in the wake of the Sept. 11 terrorist attacks. That weekend, Barron's featured a rarely bullish cover headline: "Buy Stocks Now." The article stated that stocks were then undervalued by about 17%. The piece actually inspired a rush of institutional buying for about three...

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