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Ratio of Earnings Yield to Long-Term Interest Rates

The "Fed Model" is a popular valuation model used by investors to gauge the relative valuation between stocks and bonds.  While there are several variations, in its basic form the Fed Model compares the earnings yield on the S&P 500 (inverse of P/E ratio) and the yield on long-term interest rates (10-year Treasury yield).  When the yield on the 10-year Treasury exceeds the earnings yield of the S&P 500, stocks are considered to be overvalued relative to treasuries, and vice versa when the earnings yield exceeds the yield on the 10-year Treasury.  

In the chart below, we show the ratio between the S&P 500 earnings yield and the 10-year Treasury yield.  Back in 2000, the earnings yield of the S&P 500 was half the yield of the 10-year Treasury, implying that stocks were overvalued.  For the next couple of years, the ratio increased and stocks eventually became more fairly valued relative to treasuries as the ratio hovered around 1.0 for more than four years.  Then in late 2007, the ratio began to rapidly widen as long-term interest rates cratered.  By the time the S&P 500 was ready to bottom, equities were incredibly undervalued relative to treasuries as the earnings yield climbed as high as 3.9 times the yield on the 10-year Treasury.

So what is the Fed Model saying now?  As shown, the ratio between the earnings yield and the 10-year Treasury yield is still elevated at a level of 2.24, implying that equities are undervalued.  Since 2000, the average ratio between the two measures has been 1.37.  In order to get to that level the market would have to see some combination of a rally in equities and a rise in interest rates.  While the path back to equilibrium will most likely be some combination of the two, for perspective it helps to look at both possible extremes.  Taking that approach, if the market works its way back to equilibrium solely through a rally in equities, the S&P 500 would have to trade up to 2,090 (it's at 1,280 right now). If the ratio were to get back to 1.37 through just a move in interest rates, the yield on the 10-year would have to rise to 4.92% (it's just under 3% right now).

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