Determining if Markets Are Overvalued or Undervalued: The Fed Model

Market analysts use various quantitative measurements to assess where the market is and where it might be going. While none of these measurements is accurate all the time, one of them has gained wide support among analysts, and even some support from Federal Reserve officials. In this article I will try to explain how many analysts view whether the equity markets are overvalued or undervalued. According to an article dated August 25, 1997 in Barron’s, Ed Yardeni, then economist at Deutsche Morgan Grenfell, said that Alan Greenspan at one time instructed his staff to devise a model to help him gauge the stock market. Yardeni says he found the model buried in the Fed’s semiannual monetary report to Congress. The model is simple, and compares the current yield on the 10-year Treasury note with the earnings yield on stocks. The earnings yield is the inverse of the P/E ratio.

The model works like this:

Calculate the earnings yield on stocks. (Earnings yield on stocks = Total of next 12 months of earnings per share of all companies in the S&P 500/S&P 500 Index.)

Then compare the yield on 10-Year Treasury with the earnings yield on stocks (yield on Treasury/earnings yield on stocks) – 1

Now let’s supply some real numbers, and see what the model says.

The mean estimate for the earnings of companies in the S&P 500 in the coming 12 months provided by Zack’s Investment Research is $55.37/share.

The S&P Index stands at 1007.77. The earnings yield is therefore 5.49% ($55.37/1007.77). The reciprocal (1/.0549) is the P/E of the S&P 500, 18.21 (a bit high by historical standards).

Using data from the same day (9/24), Bloomberg tells us that the current yield on the 10-year Treasury was 4.69%. Applying the numbers we get (4.69/5.49) – 1 = – 14.1. The formula is telling us that stocks are undervalued relative to bonds by 14.1%.

To see if any of this makes sense, it would be good to look at the results of these calculations over a period of years.

As you can see, over the past 10 years the relationship between stock earnings and bond yields has bottomed out at its current level just four times. Does this really mean that stock prices are going to go up? No, but it does tell us that the current relationship between bond yields and stock earnings is uncommon. Several things could happen to change the relationship and bring it back into the “normal” range:

So, of the four possibilities, two appear more likely. It therefore seems that we might see money flowing back into stocks rather soon.