What is the relationship depicted by the Fed Model?

The Fed Model illustrates the relationship between the earnings-to-price ratio, which represents the earnings yield of equities, and government bond yields. This model suggests that there is a fundamental equilibrium between these two metrics. When the earnings yield of equities is greater than the yield on government bonds, stocks may be considered undervalued relative to bonds, presenting a potential investment opportunity. Conversely, if the earnings yield is lower than bond yields, stocks might be viewed as overvalued, suggesting that investors might prefer bonds over equities.

This relationship is significant as it helps investors gauge the relative attractiveness of investing in stocks versus bonds based on prevailing economic conditions and interest rates. By comparing these two yields, the Fed Model provides insight into potential future movements in stock prices and assists in asset allocation decisions.