Federal Reserve Stock Valuation Model

March 30, 2011

As investors raise questions surrounding the prospects of both stocks and bonds as we head into the Summer, a useful exercise can be looking at the historical valuation of the two asset classes in relation to one another. A variation of Dr. Ed Yardeni’s Fed’s Stock Valuation Model can be used as a simplistic gauge of the relative valuation between the two asset classes. Working under the premise that investors must choose to allocate a limited amount of capital between stocks and bonds, the model subtracts the yield to maturity of the 10-Year U.S. Treasury Note from the earnings yield on the S&P 500 Index to develop a spread between the two.

For much of the 1990’s the spread was negative, suggesting that stocks were expensive relative to bonds. Following the burst of the tech bubble that proved stocks were in fact overvalued, the spread turned positive and has remained so ever since. It is thought that when the spread is positive stocks represent a better investment than bonds due to the higher yield. This is not necessarily the case, in an absolute sense, as one must take into account the additional risk equity investors bear. The reasoning that because stocks are inexpensive relative to bonds does not necessarily suggest that stocks are about to experience a period of positive returns. Keeping in mind that this model represents a relative valuation spread between the two assets classes, a positive spread could suggest that both assets classes are overvalued in relation to other investments – stocks just less so than bonds. Thus, while the model cannot pinpoint the overall outlook for either asset class, trends in the magnitude and direction of the spread have proven useful in the past when predicting the relative movement of stocks and bonds.