Hello everyone,
Regarding the Fed Model in Equity Market Valuation on page 148, blue box 10, question 1 seems to state that stocks are “undervalued” based on the expected earnings yield being greater than the 10 yr govt bond yield. Then the answer goes on to say that stocks are “overvalued” based on the difference between the yields being less than the historical average of .70%. (In this case .40%)
So, using the Fed Model, what’s the conclusion? Are stocks overvalued or undervaued?
Thanks
i
“In this question, the difference between the two yields is 0.40 percent. Analysts who compare the difference in yields to this average difference would contend that equities are overvalued.”
The key part is the second sentence. It’s subjective, some analysts would say under and some over. There is no right or wrong. This is a big part of level III you must understand. It requires judgement and there may not be a black and white, right or wrong. Remember the flaws of the fed model though. It doesnt factor in an equity risk premium or a growth factor so the SP500 yield should always be higher and appear “undervalued”, but is it really? Or is just because equities are riskier than treasuries and should have a higher yield…
Thanks for replying. What would an appropriate answer look like if asked in an essay question to “Using the Fed Model, determine whether the S&P 500 is over valued and undervalued relative to treasuries and justify your answer.”
And they provide you with a forward earnings yield is 4.02 and the 10 year treasury yield of 3.07.
Would I just ignore what was mentioned in the CFAI material about the .70% historical difference between earnings yield and 10 yr ylds. and state that the stock market is undervalued since the Fed Model is greater than 1?
You don’t need to know the historical by memory. They’d give it to you. If they did they would want you to answer very similar to how they did in that BB