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The fed model: The bad, the worse, and the ugly

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  • Estrada, Javier
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    Abstract

    The negative relationship between stock market P/E ratios and government bond yields seems to have become conventional wisdom among practitioners. However, limited empirical evidence and a misleading suggestion that the model originated in the Fed are used to support the model's plausibility. This article argues that the Fed model is flawed from a theoretical standpoint and reports evidence from 20 countries that seriously questions its empirical merits. Despite its widespread use and acceptance, the Fed model is found to be a failure both as a normative and as a positive model of equity pricing.

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    File URL: http://www.sciencedirect.com/science/article/B6W5X-4PR3GJ9-1/2/77aa8c6b1f811f8e1ce8f188c9ebaae6
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    Bibliographic Info

    Article provided by Elsevier in its journal The Quarterly Review of Economics and Finance.

    Volume (Year): 49 (2009)
    Issue (Month): 2 (May)
    Pages: 214-238

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    Handle: RePEc:eee:quaeco:v:49:y:2009:i:2:p:214-238

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    Web page: http://www.elsevier.com/locate/inca/620167

    Related research

    Keywords: Fed model P/E ratios Interest rates Stock market valuation;

    References

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    1. Vuolteenaho, Tuomo & Campbell, John, 2004. "Inflation Illusion and Stock Prices," Scholarly Articles 3196090, Harvard University Department of Economics.
    2. Koivu, Matti & Pennanen, Teemu & Ziemba, William T., 2005. "Cointegration analysis of the Fed model," Finance Research Letters, Elsevier, vol. 2(4), pages 248-259, December.
    3. Richard D.F. Harris & Rene Sanchez-Valle, 2000. "The Gilt-Equity Yield Ratio and the Predictability of UK and US Equity Returns," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 27(3-4), pages 333-357.
    4. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-65, September.
    5. Ritter, Jay R. & Warr, Richard S., 2002. "The Decline of Inflation and the Bull Market of 1982–1999," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 29-61, March.
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    Cited by:
    1. Geert Bekaert & Eric Engstrom, 2009. "Inflation and the Stock Market:Understanding the "Fed Model"," NBER Working Papers 15024, National Bureau of Economic Research, Inc.

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