Is the Fed’s stock valuation model working again?

The Federal Reserve's stock valuation model might be regaining relevance as Treasury yields are no longer suppressed by quantitative easing, according to Yardeni Research. The model compares the S&P 500's forward earnings yield to the 10-year U.S. Treasury yield. When the earnings yield surpasses the bond yield, stocks are deemed undervalued relative to bonds.

The model worked effectively during the 1980s and 1990s but became less useful as it consistently suggested equities were undervalued. However, it failed to forecast the market crash during the global financial crisis. Its usefulness may be returning now that Treasury yields are closer to historical norms, standing at 4.68% with a reciprocal of 21.4, while the S&P 500's forward P/E ratio is 19.9, indicating the index is slightly undervalued under the model.

Yardeni Research estimates the S&P 500's fair value to be around 8,300 with the current Treasury yield. If the 10-year yield rises above 5%, it could pose a greater risk for equities by suggesting a lower fair-value earnings multiple. This risk could increase further if higher borrowing costs heighten the likelihood of a recession.

Yardeni's base case anticipates the 10-year yield to stay between 4% and 5%, with an 80% probability assigned to the "Roaring 2020s" economic scenario. However, risks include persistent inflation, widening federal deficits, and rising government debt. U.S. public debt has reached $40 trillion, with $31 trillion in marketable securities held by the public, and annual net Treasury interest costs have reached a record $1.1 trillion.

Foreign investors hold nearly $9.3 trillion in Treasuries, though their holdings have recently plateaued. Commercial banks, on the other hand, have increased their Treasury holdings to a record $4.8 trillion in early August.