Cointegration Analysis of the Fed Model

Abstract

The Fed Model assumes that, the equity earnings yield follows the bond yield in the long run. This effect can be used to predict changes in the equity prices when the yields are far apart. Our tests based on a cointegration analysis of the United States, United Kingdom and German data indicate that the Fed model has predictive power. The predictions are better in the US than other countries and better for predicting crashes than for subsequent price rises. This approach also yields a quantification of the conditional distributions, and suggests a dynamic version of the Fed model in the form of a linear time series model.

Keywords: Cointegration analysis, Vector equilibrium correction, VAR, Stock markets

JEL Classification: G12, G14, G18, C51, C52, C53