When deciding between two securities, the main factors to consider are risk and return. Investing in stocks is relatively risky, but over the long term, there’s great potential for returns. Bonds, especially government bonds, entail very little risk but also offer comparatively lower returns over the long term. The need to compare the risk and yield of two securities has given rise to several valuation methods. One of the best known is the Fed Model. Consider working with a financial advisor to help you get accurate security valuations.
What Is The Fed Model?
The Fed Model, which has no relationship to the Federal Reserve or any government agency, compares a stock investment’s yield to the yield of government bonds. Typically this model uses the 10-year U.S. Treasury bond as the basis for comparison and measures the investment’s yield over a 12-month period.
It is important to understand the difference between yield and return. Yield is how much money an investment generates while held. It does not include the asset’s market price. Yield includes factors such as dividends and interest.
In most cases investors use the Fed Model to determine if the stock market as a whole is over- or under-valued. They do this by comparing the yield of the S&P 500 against that of the 10-year Treasury bond.
The long-term earnings yield of an investment, most often the S&P 500, is measured as dividends per share divided by price (either purchase price or current price) per share. This attempts to measure the overall value of the investment, with an emphasis on actual earnings.
Applying the Fed Model
The Fed Model attempts to determine how accurately an investment is valued. When using a market benchmark such as the S&P 500, this model measures how accurately the stock market as a whole has been valued.
- Overvalued – When an equity investment’s yield is less than the Treasury bond yield, the investment is considered to be overvalued and poised for decline.
- Undervalued – When equity investment’s yield is greater than the Treasury bond yield, the investment is considered to be undervalued and poised to increase.
So, for example, say we take the standard approach and use S&P 500 index:
- Assume the earnings yield of the S&P 500 is less than the 12-month yield on a 10-year Treasury bond. This means that stock-based investments will not give you a strong return compared to investing in a Treasury bond. The stock market is considered overvalued because you should expect that investors will soon begin selling their stocks (in favor of the highly secure gains of a bond), causing the market to decline.
- On the other hand, say the earnings yield of the S&P 500 over the next 12 months is higher than the 12-month yield of a 10-year Treasury bond. This means that investing in the stock market will net you disproportionately greater returns than buying a bond. The market is considered undervalued because you should expect that investors will soon begin buying stocks (to capture those higher gains), causing the market to grow.
When the yield on stocks exceeds that of Treasury bonds, the stock market will correct downward. When stock yields underperform compared to Treasury bonds, the market will correct upward. Another way of phrasing it is that the earnings yield of the stock market should bend towards equaling the yield on 10-year Treasury bonds.
Some traders apply the Fed Model to time the market. In an overvalued market, they sell assets to get out before an expected decrease; in an undervalued market, they buy in before an expected increase.
Criticisms of the Fed Model
In addition, this model does not account for inflation. While inflation is priced into the yield earnings of the stock market, it is not factored into the yield of Treasury bonds. This is called the “money illusion,” and it has led analysts to suggest that the Fed Model is based on a central flaw.
The Bottom Line
The Fed Model is a way of comparing the yield on securities so investors can see whether one is undervalued or overvalued in relation to the other. For example, by comparing the yield of a stock index against the yield of Treasurys, investors can decide whether stocks are returning more or less than a lower-risk alternative. Stock investments must return a profit greater than that of a U.S. Treasury bond to be worthwhile. Otherwise, investors can simply buy bonds and take the same amount of profit at zero.
It can be used to time the market: if the model shows an equity or equity index undervalued compared to Treasurys that might be an indication that it’s time to increase one’s allocation of stocks.
Tips for Investing
- A financial advisor can use various valuation models to optimize your portfolio of investments. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Treasury bonds have been one of the most popular investments in the United States for more than 80 years. They are considered one of the safest investments in the world, although they tend to give commensurately low returns.
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