Fed Model for market forecast was Fed in 22nd July 1997. This model becomes popular due to its simplicity & relative accuracy over time periods. There is simple assumption of this model that on the basis of asset with higher yield, the investors easily switch between stocks & bonds which make the returns of the stock to restore an equilibrium relationship between two assets.
The Fed has used 10-years Treasuries yield to measure bond yields. Every day this number can be viewed on updated basis. The earnings yield is used to measure stock yields. Earnings yield is obtained by dividing earnings by stock price with the help of S& P 500 Index. The earnings figure is based on operating earnings and is used for as a forward 12-months earnings estimate. For example on January 1, 2016, an estimate of operating earnings for the S&P 500 Index is used for the next 12 months through the end of the year. Similarly on April 1, 2016, an estimate of operating earnings for the next 12 month s is used through April 1, 2005. The decision rules can be formulated by using Fed Model in the following ways.
- Stocks are relatively attractive when earnings yield on S&P 500 is higher than 10-year Treasury yield.
- Stocks are relatively unattractive when the earnings yield is less than 10-year Treasury yield.
There is another alternative method of using Fed Model in which Fair Value level of S&P 500 Index is estimated and it comparison is made with the actual current Index value.
- Stocks are undervalued if the estimated fair value of the market is greater than current level of market.
- Stocks are overvalued if the estimated fair value of the market is greater than the current level of the market.
- The Fed Model further specifies that the reciprocal of the 10-year Treasuries yield is an estimate of the equilibrium P/E ratio of S&P 500. This means
- Equities are relatively attractive if the actual P/E ratio of the S&P 500 is less than estimated equilibrium P/E ratio.
- Equities are relatively unattractive if the actual P/E ratio of S&P 500 is greater than estimated equilibrium P/E ratio.
Potential Problems with the Fed Model
Greater degree of simplicity is present in the Fed Model which provides useful signals. But still there are certain problems and limitations associated with this model. The important problems are as follow.
- It is described earlier in the model that linear relationship exists between reciprocal of the yield of Treasury bond and estimated equilibrium P/E ratio. This means that the forecasted equilibrium P/E ratio is 25 with the Treasury bond yield of 4 percent. However predicted P/E ratio is 50 with Treasury bond yield of 2 percent and is 100 at 1 percent. So when interest rates are unusually low then it is highly probable that the Fed Model is not reliable because it specifies that linear relationship overstate the estimated equilibrium P/E ratio.
- Fed Model is based on the estimated earnings of S&P 500 Index for the next twelve months. This number has different estimates including bottom-up, top down and S&P core earnings which are mostly revised. So it is hard to ascertain correctly which number to use at any particular time.
- The model assumed that 10-years treasury yield can be replaced for the return on equity & for the required rate of return on equities on the S& P 500 Index. This case is not true mostly in history.
In conclusion of the Fed Model, some value able insights to investors may be offered who make effort to predict the future direction of the stock market. But care is required to use this model. It is not perfect solution to forecasting problems and investors can easily be misled by using this model especially when there are unusually low interest rates.