Let Y represent the yield on 10-year nominal Treasuries and E/P represent the equity market aggregate one-year earnings to price ratio (or earnings yield) adjusted for risk premiums. The Fed model advocates that stocks and bonds are competing investments and that Y are E/P are appropriate measures for their competing returns. As a result, stocks are seen as cheap when E/P exceeds Y, expensive when Y exceeds E/P, and fairly valued when Y and E/P are equal.

A. (5 marks) Explain why this logic is likely to be false. Hint: You need to think about what factors that drive the nominal and earning yields.

In 2021, you observed that the entire nominal yield curve has been shifting upwards i.e. nominal yields have increased across all maturities. With the increasing yields it makes sense to expect stocks to perform worse, because higher discount rates should lead to lower valuations. However, equity markets have continued their runs to an all-time high.

B. (5 marks) Discuss the potential factors that shift the yield curve upward. C. (5 marks) Explain why there seems to be a disconnect between yields and equity valuation.

Your explanation should be related to the answers in Parts A and B.