The 'Fed Model' and the Predictability of Stock Returns

Abstract

The focus of this paper is on the predictive role of the stock-bond yield gap - the difference between the stock market earnings (dividend) yield and the ten-year Treasury bond yield - also know as the Fed model. The results show that the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value and equal-weighted indexes, and it also outperforms competing predictors commonly used in the literature. These findings go in line with the predictions from a dynamic accounting identity. The absence of predictive power over dividend growth, dividend payout ratios, earnings growth, and future one-period interest rates, actually strengthens the return predictability associated with the log yield gap at very long horizons. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability over the equity premium, when the comparison is made against a simple historical average, especially when one imposes a restriction of positive equity premia. Furthermore, the yield gap proxies generally present greater out-of-sample predictability power than alternative forecasting variables. An investment strategy based on the forecasting ability of the yield gap produces significant positive certainty equivalent estimates for realistic levels of risk aversion.