Fight the fed model - The relationship between future returns and stock and bond market yields.

The "Fed model" is a popular yardstick for judging whether the stock market is fairly valued. It compares the stock market's earnings yield to the long-term government bond yield, while more traditional methods evaluate stock market valuation without regard to the level of interest rates. The Fed model is theoretically flawed, as it compares a real number to a nominal number, ignoring the fact that over the long term nominal earnings generally move in tandem with inflation. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed model fails this test-traditional methods ace it. Lack of predictive ability aside, investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower. This does not imply that the Fed model is valid, rather only that investors have historically followed it, perhaps in error. The relationship of stock and bond market yields is more complicated than conceived by the Fed model, varying systematically with perceptions of long-term stock and bond market risk. Addition of risk to the Fed model solves the puzzle of why stocks outperformed bonds for the first half of the 20th century, but have underperformed bonds since.