What is the Fed Model?

The Fed Model is a stock valuation framework that compares the earnings yield of the S&P 500 (the inverse of the price-to-earnings ratio) with the yield on the 10-year US Treasury note. When the earnings yield exceeds the Treasury yield, the model suggests equities are relatively attractive compared to bonds. When the Treasury yield is higher, bonds offer better risk-adjusted value.

The model gained its informal name from a chart that appeared in the Federal Reserve's July 1997 Humphrey-Hawkins report, though the Fed itself has never endorsed it as an official framework. The logic is intuitive: investors choosing between stocks and bonds should compare the return they can earn from each. If the S&P 500 has a 6% earnings yield and the 10-year Treasury pays 4%, stocks offer a 200-basis-point premium that compensates for their higher risk.

Critics, including many academic economists, raise important objections to the Fed Model. First, it compares a real quantity (earnings, which grow with inflation) to a nominal quantity (bond yields, which embed inflation expectations), creating an apples-to-oranges problem. During periods of high inflation, the model mechanically makes stocks look cheap even when real returns may be poor. Second, the model ignores earnings growth entirely, treating current earnings as a perpetuity rather than a growing stream. Third, it says nothing about credit risk, liquidity, or the equity risk premium that investors should rationally demand.

Despite these flaws, the Fed Model remains influential among practitioners because it captures the competitive dynamic between stocks and bonds in a single, easy-to-communicate metric. When 10-year yields spiked above 5% in late 2023, closing the gap with the S&P 500 earnings yield, it contributed to the equity selloff as "bonds became competitive again." The model works best as a rough regime indicator rather than a precise valuation tool, signaling when the relative attractiveness of asset classes has shifted meaningfully.