The criticism of Fed model is that it ignores ERP, ignores growth, and compares nominal vs real rates.
I don’t understand the third critisism. How is treasury yield nominal and how is earings yield real?
Earnings are real as they are current period earnigs stated at current rate…
Treasury yield is nominal as rate is one time fixed taking into account thw possible inflation…(Though not as much as adjusted by TIPS which are inflation adjusted)…
Earnings yield doesn’t have an inflation component, because it has already been incorporated in the expected nominal growth rate. Roughly speaking, equity investors are indifferent between a stock market with a 5% earnings yield, 20% inflation and 25% nominal growth and a market with a 5% earnings yield, 5% inflation, and 10% nominal growth. Since EY is not affected by inflation, we call it a real rate.
as others have said, your income stream from equities is assumed to adjust for inflation (eg companies put their prices up, etc) so equities offer “real” earnings.
Whereas a 5% bond will only ever pay you a 5% coupon regardless of inflation (regardless of what that money is actually worth in real terms). so it’s nominal.
good way to put it Kiakaha
Just a try with Mathematical way :
From GGM V0 = D1/(r-g) => V0 = E1*p / (r-g) where E1 = next year earning, p = payout ratio
=> E1/V0 = (r -g) / p where E1/V0 is earing yield on S&P
Now r and g both are nominal variable , ie both have real component and inflation component.
r = r (real) + Inf and g = g(real) + Inf
so when we do (r - g ) we cancel out Inf part and left with r (real) - g (real)
so we can say earning yield E1/V0 = (r - g)/p is a real variable [ignoring p as just being a ratio]
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