quiz: Fed Model

cjs238

list some limitations to it and/or times when it tends to break down. GO.

ohai

i think of this one in present terms....the FED is offering you 0% on your money market so invest in S&P with yield of 2%+ b/c they are deemed undervalued

lcw77

OK. Example.

S&P Earnings Yield = 7%
Treasury Yield = 4%

S&P 500 Index = 1000 (for simplicity's sake)
S&P 500 Index Earnings = 70

The Fed Model assumes that the S&P Earnings Yield is equal to the Treasury Yield.

Thus:

.04 = 70 / X

Solve for X

X = 1750

S&P 500 is therefore undervalued. Time to buy.

Chuckrox

nah remember this calculates the equilibrium yield. i cant find a way to logicaly remember this so I just remember this as being one of the few times where if the SP yield is higher than the FEd, it means invest in the SP because they are undervalued. go figure.

edit: banni no offense but i thought you were an indian dude for some reason.



Edited 1 time(s). Last edit at Sunday, May 15, 2011 at 07:27PM by SkipE99.

Iginla2011

hmm, ok. i guess i can talk myself into that making sense... so i have some stock that should yield me 4% and yields me 7%... winner, i'll take it! i'm sure someone smart here can tell me the real reason why this is. i thank you SkipE for adding this and i will nail it on exam day if it's a simple q like that giving the 2 #'s.

Valores

haha skipE, now you know that isn't even close to true! i've met pinkman before, so he knows it's not true either. the rest of you can think whatever you want.

former

and if the Fed Model= 4 and the SP earnings yield is 7, do you buy stocks or short em? huh huh?

lcai

nice work!
LIMITATIONS:
1. ignores equity risk premium
2. ignores earnings growth
3. compares a real variable to a nominal variable

BREAKDOWN:
- when inflation is very low
- when consumer prices are stagnant and deflation threatens (relationship b/t stock market valuation and bond yields becomes ambiguous)