Fed Up with the Fed Model | Charts that Count

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Markets are at an exciting juncture the us stock market is back at an all-time record and it’s doing that even though the bond market has seen ten-year yields go back up above 3% and that is an offense against a very popular way for valuing the stock market known as the fed model so-called because alan greenspan himself appeared to be using it when he was chairman

Of the fed let me take you through how the fed model was supposed to work now this red line here is the ten-year treasury yield and the blue line is the s&p 500 earnings yield now the earnings yield to be clear about this is effectively the inverse of the p/e ratio it’s the earnings you get on a stock divided by its price now the idea behind the fed model

Is that by comparing these two yields you can get a sensible way to value them the higher the yield on bonds then the higher the earnings yield you will require from stocks therefore in theory higher bond yields should be bad for stocks because yields move in the opposite direction from prices now if you look at the long term you can see that for a long time

These lines did indeed move very much in alignment with each other you can see why alan greenspan viewed them that way but the relationship broke down very decisively indeed at around about the turn of the century at that point you can see the stock market gets his or expensive parts of the dot-com bubble even though the fed and the greenspan had been raising

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Rates pushing up yields in an attempt to slow down the economy and since then as you can see there’s really no relationship at all between these two lines if anything they are moving in opposite directions now part of that is of course down to few e for the last decade there has been an aggressive attempt to directly interfere with the bond markets to keep bond

Yields low and so you could say that a part of part of this phenomenon of at the end of their the fed model relationship is down to qe but i think what’s more important is a way in which you wouldn’t expect these two lines to move together when bond yields are rising that implies optimism about the future for the economy and means therefore that you’re expecting

That higher rates will be necessary in future to curb a strong economy if you’re optimistic about the economy then you should also be more optimistic about stocks and prepared to pay more for them hence you get the phenomenon that we’ve had recently of a rise in both at the same time it’s a sign of returning risk appetite after years of qe of interference my

Best guess is that that is what is happening now that there was never the strength of relationship that the phase model implied and that what we are seeing now in terms of a return of optimism explains what’s happening in markets far better than the fed model ever did

Transcribed from video
Fed Up with the Fed Model | Charts that Count By Financial Times

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