Yield Gap Equity Market Timing

Article Quantpedia

Summary

The FED Model compares the aggregate equity earnings yield with the yield on long-term government bonds. This strategy estimates the stock market’s next-month excess return with a rolling predictive regression that uses the yield gap as its input. At each monthly decision, it invests fully in equities when the forecast is positive and switches fully to the risk-free asset otherwise. The page suggests that other predictors, such as the term spread or federal funds premium, could be added.

The rationale is that stocks and bonds compete for investor capital, so their relative yields may help signal expected equity returns. The cited research reports some predictive power, especially over shorter horizons and when the yield gap is historically large; it also describes stronger US evidence than international evidence. The model remains controversial: critics question comparing nominal bond yields with equity yields, and findings vary across studies and markets. The page gives no complete implementation dataset or strategy statistics, so the described signal should not be treated as a demonstrated guarantee of future returns.

Key ideas

The yield gap is calculated as the equity earnings yield minus the 10-year Treasury yield.
A monthly expanding-sample regression uses the gap to forecast the following month’s equity excess return.
The strategy holds equities when its forecast is positive and the risk-free asset otherwise.
Research summarized on the page finds some short-horizon predictive power, particularly in the United States.
The model is debated, and evidence across countries is mixed.

Using the Earnings-Bond Yield Gap for Equity Market Timing

Summary

Key ideas

Tags