Which aspect is a limitation of the Fed Model regarding equity investments?

The Fed Model is a valuation approach that compares the earnings yield on equities to the yield on government bonds, primarily focusing on the relationship between interest rates and equity valuations. One of the key limitations of the Fed Model is that it fails to account for inflation adjustments.

Inflation plays a crucial role in determining the real returns on investments. When evaluating equities against bonds, neglecting to account for inflation can lead to misinterpretations of the attractiveness of equity investments. If inflation is not considered, the earnings yield might seem higher than its real value when adjusted for inflation, potentially misleading investors about the actual purchasing power of future earnings. This oversight can result in an inaccurate assessment of the relative value between stocks and bonds, affecting investment decisions.

Understanding this limitation is critical for investors, as it emphasizes the importance of incorporating inflation expectations when analyzing the attractiveness of equity investments relative to fixed-income securities.