Markets

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

Wall Street likes to play up the Federal Reserve's role in boosting the market, but by one popular gauge at least the Fed's influence on stocks seems to be diminished.

The so-called Fed model is supposed to be able to predict when U.S. stocks are a good buy and did a reasonable job for decades. But the gauge, which compares the forward earnings yield -- the inverse of the price-to-earnings ratio -- to the yield on 10-year Treasuries hasn't offered much help recently. The S&P 500's earnings yield rose above the 10-year Treasury in March 2002 and has remained above it ever since. An investor who followed the Fed model would have been walloped during the financial crisis and received little or no warning of more minor market tumbles, like the 2011 euro crisis and the 2015 junk-bond flare-up.

Excess Yield
The once-dependable Fed model, which says investors should buy stocks when they are yielding more than bonds, missed the financial crisis, the European debt crisis and other tumbles
Source: Bloomberg

Indeed, a drop in bond yields on renewed deflation fears earlier this week should have made stocks more attractive. It didn't. The Dow Jones Industrial Average plunged 230 points on Tuesday, one of the largest single-day drops this year, though the market did recover some of those losses on Wednesday. That hasn't stopped some investors from trumpeting the power of the Fed gauge. Leuthold strategist Jim Paulsen cited it in a Barron's article over the weekend that may have partially prompted Tuesday's sell-off. The article was ominously titled "How This Bull Market Will End," even though based on current yields the Fed model suggests the Dow could reach 43,000, meaning the bull market won't end, at least not soon. Paulsen says the Fed model is not the only thing he looks at. And few people are predicting Dow 30,000, let alone anything much higher.

That's not to say the Fed model is not without its utility. Since 2009, the average spread between the S&P 500 forward earnings yield and the 10-year U.S. Treasury has been a wide 4.1 percentage points. And when the spread has been higher than that, stocks have tended to perform better. For instance, when the S&P 500 earnings yield has averaged 6 percentage points above the bond yield, as it did in late 2011 after the euro crisis sell-off, monthly returns averaged 6.7 percent. When the gap has been 3 percentage points or less, the market has produced a more lackluster monthly return of just 1.6 percent.

Less Premium
The excess yield investors are being paid to buy stocks over bonds is less than half of what it was five years ago
Source: Bloomberg

Right now, the Fed model earnings yield premium has been getting pretty thin. It has averaged 3.2 percentage points this year, which is on the low end of where it has been for much of the past decade. When it has been below that this year, the Dow has tended to fall, compared with an average gain of 1.6 percent on days when the premium is above that level. On Tuesday morning, the spread dipped to 3.1 percent points. By Wednesday, it had inched back up to just above the mid-line. The spread was as high as 3.8 percentage points when Donald Trump was elected president and stocks soared.

Diminishing Returns
When the spread between stocks' earnings yield and bond yields shrink as they have recently returns tend to fall
Source: Bloomberg
Bars represent the spread between S&P 500 earnings yield and yield of 10-year U.S. Treasuries

It's not exactly clear why investors have started to demand that stock yields trade at a significant premium to bonds, other than, you know, look around. Hurricanes are coming. Trump's tax plan is stalled. The economy is plodding along. But investors have been demanding a premium long before much of that was clear. The problem is that if falling bond yields suggest the country is headed for another recession and not an inflation-free utopia, investors are going to want to be paid a lot more to own stocks than they are now.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Stephen Gandel in New York at sgandel2@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net