The Federal Reserve model "alarms" for the first time in ten years, are U.S. stocks overvalued?

The Federal Reserve model has "sounded the alarm" for the first time in ten years, but analysts believe the issue is not significant.

On November 18, MarketWatch regular contributor Mark Hulbert stated that currently, the earnings yield of the S&P 500 is 3.90%, while the 10-year U.S. Treasury yield is 4.46%, half a percentage point higher— the last significant negative value occurred during the financial crisis of 2008-2009.

According to the Federal Reserve model, current market conditions are unfavorable for the stock market— the Federal Reserve model is a well-known market timing model that compares the earnings yield of the stock market (i.e., the inverse of the price-to-earnings ratio) with the 10-year U.S. Treasury yield. The Federal Reserve believes that when the earnings yield is higher than the 10-year U.S. Treasury yield, market conditions are favorable for the stock market, and vice versa.

However, Hulbert stated that investors do not need to worry too much, as the Federal Reserve model actually compares real yields with nominal yields, and long-term performance is weak, making the comparison results not very meaningful.

Hulbert analyzed the Federal Reserve model data starting from 1871, comparing the earnings yield with the model to predict the inflation-adjusted total returns of the stock market over the subsequent 1, 5, and 10 years.

As shown in the table below, for each indicator and time period, the table lists the R-squared, which measures the ability of one data series (in this case, the earnings yield or the Federal Reserve model) to explain or predict another data series (in this case, the stock market).

In each case, the predictive ability of using the earnings yield alone is stronger than that of the Federal Reserve model after deducting the 10-year U.S. Treasury yield in calculations.

Although the Federal Reserve model has "sounded the alarm," U.S. stocks may not be overvalued

According to the Federal Reserve model, the U.S. stock market is currently overvalued, but Hulbert stated that this may not be accurate, as the model is imprecise:

Hulbert stated that the Federal Reserve model is essentially comparing apples to oranges— the stock market's yield is a real yield, and historically, corporate earnings tend to grow faster during periods of higher inflation; while the 10-year U.S. Treasury yield is a nominal yield that does not fluctuate with inflation.

Therefore, the Federal Reserve model actually concludes by comparing real yields with nominal yields, making the comparison results naturally not very meaningful.

Cliff Asness, founder of AQR Capital Management, published a paper titled "Against the Federal Reserve Model" twenty years ago, which may be the most authoritative theoretical and empirical paper opposing the Federal Reserve model. The paper stated:

"The Federal Reserve model seems reasonable, but in reality, it does not hold. The appeal of this 'common sense' has convinced many Wall Street strategists and media commentators; however, this common sense is mostly misleading, likely due to the confusion between real returns and nominal returns (i.e., monetary illusion)."

However, Hulbert also cautioned that while the Federal Reserve model cannot prove that the U.S. stock market is overvalued, it does not mean that the U.S. stock market is not overvalued; investors may have other evidence to prove that the U.S. stock market is indeed overvalued.