The FED Model and Expected Asset Returns

Abstract

The focus of this paper is on the predictive role of the stock-bond yield gap - the difference between the market earnings yield and the ten-year Treasury bond yield - also know as the FED model, and which can be interpreted as a long-term yield or return spread of equities relative to bonds. Conditional on other forecasting variables, the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value and equal-weighted indexes. On the other hand, the yield gap forecasts negative excess returns for bonds, at both short and long horizons. These findings go in line with the predictions from a dynamic accounting identity. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability over both stock market and long-term bond returns, when the comparison is made against both a simple historical average and an autoregressive specification. Furthermore, the yield gap proxies have greater out-of-sample predictability power than alternative forecasting variables. An investment strategy based on the forecasting ability of the yield gap produces higher Sharpe ratios than passive strategies in both the market index and long-term bond, and in addition, the certainty equivalent estimates are in general positive.