What Is the Fed Model and How Does It Work in Finance?

Investors and analysts use various models to assess whether the stock market is overvalued or undervalued. One such approach is the Fed Model, which compares stock earnings yields with Treasury bond yields to gauge relative attractiveness. While not an official Federal Reserve tool, it gained popularity after being referenced in a 1997 report by former Fed Chairman Alan Greenspan.

This model helps investors evaluate asset allocation and market valuation. However, like any financial metric, it has limitations and should be used alongside other indicators for a more complete picture.

Core Components

The Fed Model is based on the idea that investors compare expected returns from equities and bonds to decide where to allocate capital. This comparison relies on two key metrics: Treasury yields and earnings yields.

Treasury Yield

Treasury yields represent the return investors can expect from holding U.S. government debt securities. These yields fluctuate based on Federal Reserve policy, inflation expectations, and economic conditions. When interest rates rise, bond prices fall, leading to higher yields. Declining rates result in lower yields. Since U.S. Treasury securities are considered virtually risk-free due to government backing, their yields serve as a benchmark for evaluating other investments, including equities.

The 10-year Treasury yield is commonly used in the Fed Model because it reflects long-term interest rate expectations and provides a standard measure for comparing returns across asset classes. A rising Treasury yield can make bonds more attractive relative to stocks, while a declining yield can push investors toward equities.

Earnings Yield

Earnings yield is calculated as a company’s earnings per share (EPS) divided by its stock price, expressed as a percentage. It is the inverse of the price-to-earnings (P/E) ratio. A higher earnings yield suggests investors receive more earnings per dollar invested, while a lower yield indicates weaker returns.

Unlike Treasury yields, which are influenced by monetary policy and market conditions, earnings yields depend on corporate profitability, economic growth, and investor sentiment. The Fed Model uses the earnings yield of a broad stock market index, such as the S&P 500, for comparison with Treasury yields. If earnings yields are significantly higher than bond yields, stocks may be undervalued. If the gap narrows or reverses, equities might be less attractive.

Relationship Between the Two

The Fed Model assumes stock market valuations and bond yields should move in tandem. When Treasury yields rise, bonds become more appealing, potentially drawing investment away from stocks and pressuring equity prices downward. Conversely, when bond yields decline, stocks may appear more attractive, leading to capital inflows and rising market valuations.

Critics argue that the model overlooks factors such as risk premiums, corporate earnings growth, and macroeconomic dynamics. Historical data also shows that the correlation between earnings yields and Treasury yields is not always consistent, particularly during financial crises or periods of unconventional monetary policy.

Steps to Derive the Model

Applying the Fed Model requires gathering reliable financial data. Investors typically source earnings estimates from financial reports or analyst projections, ensuring they reflect forward-looking expectations rather than historical figures. Using forward earnings estimates aligns with how market participants value stocks based on anticipated profitability.

Treasury yields are obtained from market data, with the 10-year Treasury yield commonly used as the benchmark.

Once the data is collected, the market’s earnings yield is calculated by taking the projected aggregate earnings of a stock index and dividing it by its total market capitalization. This percentage allows for direct comparison with Treasury yields. Since earnings estimates fluctuate, frequent updates are necessary.

After determining both yields, investors analyze their relationship. A significant gap between earnings yields and Treasury yields can influence asset allocation. A wider spread may suggest equities are undervalued relative to bonds, while a narrowing or negative spread could indicate an overheated market. External factors such as inflation expectations, Federal Reserve policy shifts, and geopolitical events also impact both earnings projections and bond yields.

Interpreting Numerical Outcomes

The difference between earnings yields and Treasury yields provides insight into market sentiment. A wide gap, where the earnings yield is significantly higher, often signals that equities may be undervalued compared to bonds. This can indicate strong corporate earnings growth or investor skepticism about future economic conditions. If the gap is unusually large, it may suggest stock prices are lagging behind earnings potential due to uncertainties such as monetary policy shifts or geopolitical risks.

A narrow spread, where the two yields are close together, suggests a more balanced attractiveness between stocks and bonds. This often occurs in stable economic conditions where interest rates and corporate earnings expectations are aligned. However, if the earnings yield drops below Treasury yields, it raises concerns that stocks are overvalued. This scenario implies investors are accepting lower returns from equities despite their inherent risk, which can indicate excessive optimism or speculative behavior.

Beyond the absolute comparison, the direction of change in these yields also matters. If Treasury yields rise while earnings yields remain stagnant or decline, stock valuations could come under pressure as fixed-income investments become more appealing. On the other hand, if earnings yields increase due to improving corporate profitability while bond yields remain stable, equities may continue to attract investment. Observing how these figures evolve over time helps investors anticipate market shifts and adjust strategies accordingly.

Common Misconceptions

Many assume the Fed Model predicts market direction, but it is a relative valuation tool rather than a forecasting mechanism. It does not account for macroeconomic shocks, sector-specific risks, or investor sentiment shifts that can drive market movements independently of earnings yields and bond yields. For instance, during periods of quantitative easing, artificially suppressed Treasury yields may distort the model’s signals, making stocks appear undervalued when broader economic conditions suggest otherwise.

Another misconception is that all stock market environments conform to the model’s framework. Structural changes in investor behavior and monetary policy can weaken its applicability. During low-interest-rate eras, such as the 2010s, many investors prioritized growth stocks despite their low earnings yields, challenging the model’s assumption that equities and bonds remain directly comparable. The rise of alternative asset classes, such as private equity and cryptocurrencies, has also introduced new competition for capital, further complicating the stock-bond valuation relationship.