Is the Fed’s stock valuation model working again?

The Federal Reserve's stock valuation model may be regaining relevance as Treasury yields are no longer suppressed by quantitative easing, according to Yardeni Research. This model compares the S&P 500's forward earnings yield to the 10-year U.S. Treasury yield, with stocks considered undervalued when their earnings yield exceeds the government bond yield.

In recent months, the model has shown the S&P 500 to be slightly undervalued, with the 10-year yield at 4.68% and a reciprocal of 21.4 compared to the S&P 500's forward P/E ratio of 19.9. This suggests the index remains slightly undervalued under the model, with an estimated fair value of around 8,300. However, higher yields above 5% could pose a risk to equities, while a recession could exacerbate the downside.

Yardeni's base case calls for the 10-year yield to remain between 4% and 5%, with an 80% probability assigned to the "Roaring 2020s" economic scenario. The risks include persistent inflation, widening federal deficits, and rising government debt.

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