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The Fed’s Model Is Broken

Submitted by Tyler Durden on 11/15/2012 18:59 -0500 ZeroHedge

One of the most commonly cited ‘bullish’ memes for stocks is the so-called Fed Model (or Equity Risk Premium) or more simply – the fact that earnings yields are not catching up to Treasury yields (i.e. why put your money in government bonds at such low rates when there is smorgasbord of yummy equities with ‘attractive’ dividend yields). There are three key problems with this perspective: 1) No concept of ‘risk’ is imbibed in this return-based differential (as we have discussed before here and here); 2) Longer-term historical context is critical (as we discussed here – must read); and most importantly 3) Financial Repression breaks the ‘Fed Model’. As Barclays shows in the following three charts (and we pointed out recentlynormalization of the equity risk premium will not occur until Financial Repression ends.


The Fed Model has broken – what are asset allocators to do? This occurred two other times in history…

As it seems in reality, the perceived risk differential between bonds and stocks is indeed critical in confirming the Fed Model… and that differential has become majorly disconnected since the crisis began (*and rightly so).

Critically, just as we saw with the Great Depression, once the Fed removed itself (or reduced itself) by ending its then QE program of financial repression, then markets can clear and signal capital to move into not incorrectly-attractive investments…

So the next time someone throws the “So what you gonna do? Put your money in Treasuries at 2% yields?” line at you; kindly stroke your chin (reflectively), pause (philosophically), and tell them that until the Fed takes its boot off the interest-rate neck of the nation and stops buying every bond in sight, the risk-reward favors non-equities – and as any good entrepreneur putting their hard-earned capital to work knows ‘a fed-induced period of mal-investment’ can only end one way – and if you are patient, there will be plenty of ‘opportunities’ when that end begins.

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