A rapid rise in bond yields prompts arguments that stocks become relatively less attractive in terms of future total returns. This view is motivated by the so-called “Fed Model” which argues that risky stocks should offer investors a higher yield than less risky bonds. Stocks are relatively “overvalued” when their earnings yield approaches or falls below bond yields. While declining earnings yield signals that stock prices are too high and future stock total returns may be muted, higher bond yields signify stronger future bond total returns since bond yields are a good forecast of their future total returns if held to maturity.

We explore the historical record of the Fed Model to explain future stock-bond relative total returns. This may be useful information for investors because relative expected returns are an important input to asset allocation decisions. Using the past 50y of data, has the Fed Model provided a reliable signal for future stock-bond relative, risk-adjusted, total return?

CIO Takeaways

1. The recent stock-bond real yield difference of 1.1%/y (as of September 2023) has historically been associated with stocks outperforming bonds in terms of average return by 2.4%/y (vs. the historical average of 4.4%/y outperformance) over the subsequent 10y.
2. However, in terms of volatility-adjusted return (i.e., annualized mean/vol ratio), the recent stock-bond real yield difference has been associated with bonds outperforming stocks by 0.07 (vs. the historical average of stocks outperforming bonds by 0.23) over the subsequent 10y.