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Posted by Prem on Saturday, April 23, 2011 | Tags : Equity Valuation
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The Fed Model, which was named by Edward Yardeni, can be used to check whether the market is undervalued or overvalued at a point of time. The Fed model is based on the Humphrey Hawkins report presented to Congress on 22 July 1997. In the report, US Federal Reserve compared the 10 years T-note yield to the earnings yield of S&P500 for 1982 to 1997. However, it should be noted that the Fed model was never used to formulate policies by Federal Reserve. The name is somewhat misleading in its sense.
Before understanding Fed Model, let us understand how the earning yield of S&P 500 index is found out. The earning yield of index is the forward operating earnings divided by the index level.
The Fed Model states that the 10 years Treasury note yield should be equal to the earnings yields of S&P 500 index in equilibrium. If a difference exists between these two parameters, than market is said to be overvalued or undervalued.
The Fed Model predicts that the stocks are undervalued if the earnings yield of index is greater than the 10 years T note yield and the stocks are overvalued if the earnings yield of index is less than the 10 years note yield.
For example, if the earnings yields of Index is 5% and the 10 years T note yield is 4.5%, than the stocks is considered to be undervalued.
In other words, it can also be said that if the difference between earnings yield of index and 10 years T note yield is positive, than stocks are considered to be undervalued and if the difference between earnings yield of index and 10 years T note yield is negative, than the stocks are considered to be overvalued. The larger the positive figure, the more the stock market will be in boom and the larger the negative figure, the more the stock market will fall down. It is noted that the largest difference occurred prior to collapse of stock market bubble in October 1987 and early 2000.
The major drawbacks of the Fed model is that it doesn't factor in the equity risk premium, inflation and earnings growth opportunities. The Yardeni Model address some of the criticisms of Fed Model. In spite of criticisms, the Fed Model is important for an investor to predict whether the stock market is undervalued or overvalued. It does suggest that when the interest rate fall, the stocks become a more attractive asset class.