Evaluating the ‘Fed Model’ of Stock Price Valuation: An out-of-sample forecasting perspective

The “Fed Model” postulates a cointegrating relationship between the equity yield on the S&P 500 and the bond yield. We evaluate the Fed Model as a vector error correction forecasting model for stock prices and for bond yields. We compare out-of-sample forecasts of each of these two variables from a univariate model and various versions of the Fed Model including both linear and nonlinear vector error correction models. We find that for stock prices the Fed Model improves on the univariate model for longer-horizon forecasts, and the nonlinear vector error correction model performs even better than its linear version.