Fed Model

Many agree and its mere common sense, that the way to measure value in any asset, is by comparing (the expected earnings due from) the investment you're evaluating to the earnings you get on a risk-free investment. If you earn more on a risk free investment that this particular investment (which is not risk free) than this investment is overvalued, but if you do earn more, than this investment (even though it has risk and its uncertain) may be a value or undervalued.

The "Fed model" is based on that theory and thought to be used by the Federal Reserve, it hypothesizes a relationship between long-term treasury notes (considered risk-free) and the return of equities. According to this valuation model, the yield on the 10-year U.S. Treasury Bonds should be similar to the S&P 500 earnings yield. Differences in these returns identify an over-priced or under-priced securities market. For example, if the net earnings for the 500 companies in the S&P are $50 per share and the cost of the S&P is $500, then the earnings you receive for a $500 investment is at a rate of 10 %. And if at the same time, the 10 year government bond yields 8%. This indicated that the S&P is undervalued by 2%. (Even the earnings on the S&P may go down verses the Bond yield which is fixed, so you can ask how can you compare one to an other? The answer is, that on the other hand the earnings on the S&P may go up verses the yield which is fixed, so the potential gain washes off the potential loss.)

However, the market – much like any other asset – may be undervalued or overvalued for many years. Thus, you cannot use this model for a timing strategy, as it is far from perfect. But, the market crashes in 1987, 1998 and 2001 occurred during an overvalued market. that's why It is important to know whether the asset you hold is overvalued or undervalued. 

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