The Fed Model is a theory of equity valuation used by some security analysts that hypothesizes a relationship between long-term treasury notes and the expected return on equities.
According to this valuation model, in equilibrium the real yield on the 10-year U.S. Treasury Bonds should be similar to the S&P 500 earnings yield (that is, S&P forward earnings divided by the S&P level).[citation needed] Differences in these yields identify an over-priced or under-priced equity market.
More specifically, if the S&P earnings yield is higher than the treasury yield investors should sell treasuries and buy stocks (i.e. stocks are undervalued), while if the S&P earnings yield is lower investors should sell stocks and buy the more attractive treasuries (i.e. stocks are overvalued). The Fed Model was so named by Ed Yardeni of Prudential Securities based on the fact that some research at the Federal Reserve in the mid 1990’s used similar ideas.[1] But the model goes back much further than this and can be found in various forms in a number of security analysis books. In this sense, the term Fed Model is misleading, and the model is definitely not endorsed by the Fed.
- S&P 500: 6.40%
- 10YR T-Note: 2.21%
6.40 – 2.21 = 4.19%
So, if stocks are so attractive, why is no one buying?