The 'Fed Model' and the Predictability of Stock Returns

The focus of this paper is on the predictive role of the stock-bond yield gap---the difference between the stock market earnings (dividend) yield and the ten-year Treasury bond yield---also know as the quot;Fed modelquot;. The results show that the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value and equal-weighted stock indexes, and it also outperforms competing predictors commonly used in the literature. These findings go in line with the predictions from a present-value decomposition. The absence of predictive power for dividend growth, dividend payout ratios, earnings growth, and future one-period interest rates, actually strengthens the return predictability associated with the yield gap at very long horizons. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability for the equity premium when the comparison is made against a simple historical average, especially when one imposes a restriction of positive equity premia. Furthermore, the yield gap proxies generally show greater out-of-sample forecasting power than the alternative state variables. An investment strategy based on the forecasting ability of the yield gap produces significant gains in Sharpe ratios