Discounting the Fed Model

This week’s Buttonwood column examines the Fed model. This rule of thumb compares bond yields to the inverse of price-earnings ratios of equities (or, simply, the earnings yield). It is widely considered a flawed model as it ignores risk, inflation and growth, but that doesn’t stop some people pushing it to help their cause. Proponents argue that when bond yields are below the earnings yield, equities are worth buying. However, neither the theory nor the data back up the view that equity prices should always be higher because bond yields are lower.

Future real equity returns were negative when bond yields were at their lowest and high when bond yields were highest.

All else equal, lower bond yields make equities relatively more attractive and increase the prices investors are willing to pay. This simultaneously lowers the discount rates, or costs of equity, and hence the returns investors can expect to earn. However inflation, growth and risk can offset this effect. Higher nominal growth increases the value of equities while higher prospective risk around cash flows does the opposite. The conclusion from the quote above is that investors (possibly blindly following some version of the Fed model) have tended to pay too much attention to the role of the discount rate and too little to what else is going on.

In a low growth world with little in the way of inflationary pressures, and no signs of risks abating, earnings yields should be quite a bit higher than the yield on bonds. And they are. But in the unlikely event that the earnings yield falls and the gap gets close to zero,  investors should be worried. It is more likely that the gap will narrow because bond yields increase. In that case, equities would lose some of the luster that the Fed model ostensibly gives them now.

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