What Kinds of Market Returns Should We Expect?

You hear a lot about the “Fed Model” when discussions break out about valuing equities versus bonds. Larry Kudlow loves talking about this strategy on CNBC to back up his never-ending bullish stance on stocks. The model, simply speaking, compares the earnings yield on the stock market to the 10-year treasury bond yield.

If the S&P 500 trades at a 20 P/E, it’s earnings yield is 5% (100/20). Since this compares favorably with the 4% treasury yield, Kudlow will argue that stocks are more attractive than bonds, and therefore should be bought. The thinking goes that if both investments were fairly valued, relative to each other, then their yields would be equal.

However, there is a problem with this so-called model. The equity market and the bond market hardly ever “yield” the same amount. As a result, any model that aims to make them equal is inherently flawed. If stocks and bonds were supposed to be relatively equal in value, it would make sense to base investment decisions on any discrepency, such as 4% versus 5% yields. If such discrepencies are extremely common, there is little reason to conclude they signal relative attractiveness or unattractiveness.

Let’s show some evidence to further conclude that the Fed Model shouldn’t be used as a powerful investment tool. When bond yields are historically low, as they are today, the Fed Model would predict a high level of attractivenness for equities as an investment class. After all, the lower the yield on bonds, the more likely stock earnings yields would surpass them.

Below you will see various ranges for the 10-year Treasury bond yield since 1965, along with the actual total return that the S&P 500 achieved over the following 10-year period. As you can see, low bond yields have not resulted in attractive stock price returns. In fact, one can argue the exact opposite.

10-Year Bond Yield —–Subsequent S&P 500 returns
——— 0-5% ——————— 4.3%
——— 5-6%———————- 5.5%
——— 6-7% ——————– 10.5%
——— 7-8% ——————– 13.2%
——— 8-9% ——————– 16.7%
——— 9-10% ——————- 17.5%