The Predictive Ability of the Bond-Stock Earnings Yield Differential Model

Klaus Berge, Giorgio Consigli and William T. Ziemba
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Klaus Berge: Allianz SE in Munich, Germany
Giorgio Consigli: Department of Mathematics, Statistics, and Computer Science at the University of Bergamo in Bergamo, Italy

Chapter 20 in Calendar Anomalies and Arbitrage, 2012, pp 445-462 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractThe Federal Reserve (Fed) model provides a framework for discussing stock market over- and undervaluation. It was introduced by market practitioners after Alan Greenspan’s speech on the market’s irrational exuberance in November 1996 as an attempt to understand and predict variations in the equity risk premium (ERP). The model relates the yield on stocks (measured by the ratio of earnings to stock prices) to the yield on nominal Treasury bonds. The theory behind the Fed model is that an optimal asset allocation between stocks and bonds is related to their relative yields and when the bond yield is too high, a market adjustment is needed resulting in a shift out of stocks into bonds. If the adjustment is large, it causes an equity market correction (a decline of 10% within one year); hence. there is a short-term negative ERP. The model predicted the 1987 US., 1990 Japan, 2000 US., and 2002 US. corrections…

Keywords: Calendar Anomalies; Arbitrage; Stock Prices; Stock Returns; US Stock Market; Futures Markets; Betting; Trading Strategies; Sports Market; Lottery Market; Capital Growth Theory; Semi-Strong Market Efficiency; Speculative Investments; Index Futures; Factor Models Based on Fundamental Anomalies; Worldwide Stock Market Strategies (search for similar items in EconPapers)
Date: 2012
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