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What is the Fed Model?
The Fed model is a metric that compares the earning yields of the S&P 500 with the yield generated by a long-term (10 years) U.S Treasury bonds to determine whether bond rates are set appropriately.
How Does the Fed Model Work?
The Fed model was created by Ed Yardeni, a financial economist. The Feds stock valuation represents a market tool used in determining whether the U.S stock market is fairly valued. The Fed model maintains that there is a bullish trend in the market if the S&P 500 earnings yield is higher than the yield on the U.S 10-year bonds. The reverse is the case when the U.S 10-year bonds yield is higher than the S&P 500 earnings yield. It means there is a bearish market. A bullish market is one that assumes that the prices of stocks will increase and investors can accumulate shares, while a bearish market posits that stock prices will decrease.
Generally, the Fed model is an indicator of whether the U.S stock market is fairly-valued or otherwise. Before the Great Recession in 2008, the Fed model was used as an indicator of economic problems. The failure of the model to give indication of the pending Great Recession has lead to increased criticism of the metric.