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A key point on the U.S. stock market flows from the so-called "FED" model.

It is called the FED model because this is a model the Federal Reserve uses.

What it says is that if you flip the Price-Earnings (P/E) valuation ratio for S&P 500 stocks upside down (to E/P), you effectively have an implied cash flow yield on stocks, much like an interest rate.

If you think that annual stock cash flow returns should track annual bond interest rate returns, then you understand the logic of this model. The two major asset class cash flow returns should track one another, as investors seek the best place to put money to work. No opportunities to arbitrage are left on the table.

In terms of the FED model then, the E/P ratio of stocks should track some widely accepted benchmark in long-term interest rates. In the eyes of most people, this is the 10-year U.S. Treasury rate.

See below – the Treasury 10-yr bond rate is purple; the S&P500 E/P ratio is red.



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What does a person find when you look at this relationship?

It held together reasonably well from 1981 until 1999, when stock market valuation went on a big rise, tracking a downward path of long-term interest rates. However, perhaps since 1999, and certainly since the 2008 financial chaos, this yield relationship has broken down.

Since 2008, it is not true these relationships track one another.

For example, as the chart in this article shows (with the purple line), we have had the 10-year U.S. Treasury interest rate decline from around 4.5% in 2000 to around 2.0% today. The corresponding E/P ratio for stocks (which is the red line) should have gone down with it, meaning a big rise in stocks. Instead, the red line E/P ratio has gone from something like 4.5% to something near 7%.

The Key Point: Sitting in Q4, the FED earnings valuation model implies there is much more yield to be had from owning a stock than a bond.

Forecasts for the 10-year U.S. Treasury offer 50-75 basis points more yield over the coming year. Zero rates are forecast at short-end maturities for at least two more years. It appears unlikely much incentive is in place to move into fixed-income securities coming purely from interest rates they pay. Since 2008, the real attraction to all maturities of fixed income is preserving capital: Safe Haven.

To restore this historic relationship between stock and bond yields, we need to see the 10-year risk-free U.S. Treasury rate start rising again. And stock prices in the S&P 500 index race ahead of annual earnings growth rates.

In other words, revived demand for long-term finance needs to happen in the bond market (i.e. strong loan demand), and a valuation, or P/E multiple expansion, needs to happen to the stock market (i.e. optimism).

Stronger-than-expected payrolls and an uptick in real GDP growth would do the trick.

For Q3, we have seen a pick-up in bank earnings from stronger mortgage loan making. And some of the highest consumer confidence numbers in four years. This FED model may start to gain a little traction. At the least, the latest S&P 500 earnings numbers in the FED model context offer another bullish sign.

The FED model shows U.S. equity markets can run for some time until this historic earnings yield relationship is restored.

Happy Investing! John Blank

John Blank is Chief Equity Strategist at Zacks. He provides a critically analytical view of the markets and the forces driving them. With the FED model providing bullish signals, now is a perfect time to see for yourself all of the services Zacks offers. From long-term investment strategies to short-term trading alerts, we offer a service to match your portfolio goals and risk tolerance. The best way to discover all we have to offer is with our Zacks Ultimate service. You’ll see first-hand all of the trades, picks, and insightful commentary of all of our editors. And then you can decide for yourself which is best for you.

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