this earnings yield fell below the bond yield and “undervalued” when-
ever the reverse occurred. The analysis showed that the market was
most overvalued in August 1987, just before the October 1987 stock mar-
ket crash, and most undervalued in the early 1980s, when the great bull
market began.
The basic idea behind the Fed model is that bonds are the chief alter-
native for stocks in investors’ portfolios. When the bond yields rise above
the earnings yields, stock prices fall because investors shift their portfolio
holdings from stocks to bonds. On the other hand, when the bond yields
fall below the earnings yields, investors shift to stocks from bonds.
Figure 7-4 shows that the Fed model appeared to work fairly well be-
ginning in 1970. When interest rates fell, stocks rallied to bring the earn-
ings yields down, and the opposite occurred when interest rates rose.
What is surprising is that this relation held despite the fact that
stocks and bonds are very different assets. Government bonds have
ironclad guarantees to pay a specified number of dollars over time but
bear the risk of inflation. Stocks, on the other hand, are real assets whose
prices will rise with inflation, but they bear the risk of the uncertainty of
114 PART 2 Valuation, Style Investing, and Global Markets
FIGURE 7–4
Fed Model of Stock Market Valuation, 1926 through December 2006