Way back in 1997, the federal reserve surprised the financial community with comments relating to the S&P 500 and interest rates.
“The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming twelve months has risen further from levels that were already unusually high. Changes in this ratio have often been inversely related to changes in long-term Treasury yields, but this year's stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown.”
They even went as far as to include a chart of the S&P 500 earnings-price ratio versus US 10-year Treasury note yield.
In the days following the Federal Reserve's startling stock-earnings-yield-US-Treasury-rate observation, the famed market strategist, Ed Yardeni (then with Deutsche Morgan Grenfell), immortalized this relationship as the “Fed Model.” Although the Federal Reserve has never officially endorsed this model, the name stuck. Not only did it stick, but overnight, Wall Street strategists were busy trying to make sense of the recent divergence that Fed Chairman Alan Greenspan had noted.
Since then, tons of economic wonks have written all sorts of academic papers poking holes in the model, but I kind of think they are missing the big picture. It was never intended to be some sort of comprehensive forecasting tool that could predict future stock index performance. Its use could better be described as a broad barometer that gives a general sense of under or overvaluation of equities versus interest rates. Much like when a doctor uses a thermometer to tell whether a patient is sick or not, it is far from the definitive guide as to the market's health, but merely one more item for the toolbox.