A model that compares the returns from the 10-year Treasury note and the Standard & Poor 500 to deter- mine whether stocks are overvalued. The expected return from both instruments should be roughly the same. The Treasury’s return, or its yield, is compared to the stocks’ earnings yield, which is the expected earnings divided by price. Rising stock prices that surpass expected earnings cause the earnings yield to fall. If earnings fall below the 10-year Treasury yield, stocks are overvalued. There is little incentive to buy potentially risky stocks if they don’t even earn as much as risk-free Treasuries.
The Fed Model was constructed by Ed Yardeni, the chief investment strategist at Prudential Securities as of this printing. He constructed the model from comments made in a Federal Reserve report to Congress in July 1997. The report included a paragraph that said the yield on the 10-year Treasury note at that point far exceeded stocks’ earnings yield.