Cointegration analysis of the Fed model

Matti Koivu
Department of Management Science, Helsinki School of Economics, Finland

Teemu Pennanen
Department of Management Science, Helsinki School of Economics, Finland

William T. Ziemba ∗
Sauder School of Business, University of British Columbia, Vancouver, Canada
and Sloan School of Management, Massachusetts Institute of Technology,
Cambridge , Massachusetts, USA

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 predic-
tive 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.

Key words: Co-integration analysis, Vector equilibrium correction, VAR, Stock

markets

1 Introduction

Historical studies of stock prices over long periods of time of one hundred
years and more appear in Constantinides (2002), Dimson et al. (2002) and
∗ Corresponding author.
Email addresses: matti.koivu@hkkk.fi (Matti Koivu),
teemu.pennanen@hkkk.fi (Teemu Pennanen), ziemba@interchange.ubc.ca
(William T. Ziemba).

Preprint submitted to Elsevier Science 6 March 2005

Siegel (2002). They show that stock prices dominate other asset classes such
as bonds, cash (T-bills) and gold over long periods of time. However, there are
periods when stock prices under perform and some of these periods have been
very long. Siegel (2002) shows that for the US 1899 to 1919, 1929 to 1954 and
1964 to 1981 had zero cumulative nominal returns not counting dividends.
Campbell and Shiller (1998, 2001) and Shiller (2000) examine price-earnings
ratios, dividend yields and other measures of overpriced stock markets. They
argued that the US stock market was overpriced in the late 1990’s and the
subsequent decline until March 2003 brought the market back to historically
more typical price-earnings levels. Their studies considered stock dividend
rates, price-earnings ratios, etc. in comparison to historical values.

In studies of the Japanese stock market, Ziemba and Schwartz (1991) used a
long bond minus earnings yield (earnings divided by stock price) model as a
stock market danger indicator. The idea is that in strategic asset allocation
bonds and stocks compete for investment funds and those funds tend to move
towards the more attractive investment. When bond yields are high, bonds
provide high coupons plus capital gains should interest rates decline. Mean-
while, stocks future values measured by the discounted sum of future earnings
are low, because of these high interest rates. Hence, when this spread is well
above historical norms stocks tend to crash to move the bond-stock measure
back into historical levels. Ziemba and Schwartz (1991) showed that this mea-
sure predicted the October 1987 crash in the US and in Japan. They studied
this measure during 1948 to 1989 and found that whenever the measure was
in the 95% confidence danger zone there was a decline of 10% or more within
one year. The measure was in the 99% confidence danger zone in late 1989
prior to the 1990-91 decline of the Nikkei stock average. There were other 10%
declines not predicted by this measure, but the measure was 100% accurate
in predicting major crashes in this 43 year period. Berge and Ziemba (2003)
made a further study of the predictive ability of this measure for predicting
stock price rises and declines with various data estimation techniques for the
US, Japan, Germany, Canada and the UK. For 1970-2003 Berge and Ziemba
(2003) found that the measure provided signals to enter and exit the stock
markets superior to buy and hold strategy and provided signals that predicted
large declines. Practioners such as Yardeni (2003) have also used this measure
to try signal large stock market moves. Typically stock prices continue to in-
crease when the measure moves into the “danger zone” and suggests a decline;
however, the stock prices eventually decline, that is, fall 10% or more from the
initial signal level within one year. Similarly stock prices continue to fall when
the measure suggests an increase but they eventually rise. This model is more
effective in the US and Japan and less effective in Germany, Canada and the
UK. A logarithmic ratio of long bond to stock yields as studied in this paper
is widely believed to be used by the Federal Reserve system in their economic
analyses.

2
Figure 1 shows that the indicator at extreme values predicts the 1987 and
2000-2001 stock market crashes. During 2001 stock market prices fell and
the indicator moved to a lower level indicating less danger in the market.
However, in late 2001, the fall in stock market prices was exceeded by the fall
in earnings. This lead to the indicator moving even higher into the danger
zone which predicted the 22% fall in the stock prices in 2002. In late 2002 the
indicator moved to a low level and the rise in stock prices in 2003 is consistent
with that.
7.5 5.4

7 5.2

6.5 5

6 4.8

5.5 4.6

5 4.4

4.5 4.2

4 4
80 82 84 86 88 90 92 94 96 98 00 02

Fig. 1. Datastream US market index and the Log Indicator (right scale, dotted line).

Section 2 discusses the data used. In Section 3, we perform a cointegration

analysis of the Fed model using data from the United States, the United
Kingdom and Germany. This gives estimates of the strength and the delay of
the influence of the yield spread on equity prices over time.

Based on the results in Section 3, we build a Vector Equilibrium Correction

(VEqC) forecasting model for the bond yield, equity prices and earnings in
Section 4. This model incorporates statistical data with expert information.
The expert information comes in the form of the Fed model effect and user
specified drift parameters. Section 5 has out of sample tests of the model, and
Section 6 concludes.

2 Data

The stock market price data for the three markets are from Datastream. Total
market price indices for the United States, United Kingdom and Germany rep-
resent the behavior of the stock prices in all three markets. The earnings (past)
corresponding to the indices are calculated from the reported P/E ratios. The
bond yields represent the yields on ten-year government benchmark bonds and
are calculated by Datastream. Our dataset covers quarterly observations from
January 1980 to December 2003.

3
3 Tests for co-integration

Denote the bond yield, equity price and earnings by Yt , Pt and Et , respectively.
Since these series are all positive suggests working with their logarithms. This
forces concentration on proportional value changes, and it guarantees that
negative values never occur. The logarithmic indicator is
à !
Yt
It = ln = ln Yt − ln Et + ln Pt . (1)
Et /Pt

Figures 2–4 display the historical values of ln Yti , ln Pti , ln Eti and Iti from
1980/1 to 2003/4, respectively, where i = U S, GER and U K. Even though
the log bond yield, stock price index and earnings appear non-stationary, their
linear combinations (Iti ) seem stationary in every market; see Figures 2–4 .
2.8 7.5 5.4
ln P
7 ln E
2.6
6.5 5.2

2.4
6
5
2.2 5.5

5
2 4.8
4.5
1.8 4
4.6
3.5
1.6
3 4.4
1.4
2.5

1.2 2 4.2
80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02

(a) ln YtU S . (b) ln PtU S (solid line) and (c) ItU S .

ln EtU S .

Fig. 2. Logarithmic time series for the United States.

2.8 8.5 5.4
ln P
ln E
8
2.6 5.2
7.5

2.4 7 5

6.5
2.2 4.8
6
2 4.6
5.5

1.8 5 4.4

4.5
1.6 4.2
4

1.4 3.5 4
80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02

(a) ln YtU K . (b) ln PtU K (solid line) and (c) ItU K .

ln EtU K .

Fig. 3. Logarithmic time series for the United Kingdom.

We study, using data from 1980/1–2000/1, the stationarity properties of ln Yti ,

ln Pti , ln Eti and Iti by performing augmented Dickey-Fuller tests for all the
time series. The lag lengths in the tests have been selected using the Schwarz
information criterion with a maximum of twelve lags. The value of z(t) in
Table 1 indicates the deterministic terms included in the unit root regressions.
When z(t) = 0 the deterministic terms are omitted, with z(t) = 1 a constant
is included and with z(t) = (1, t) a constant and a trend are included.

4
 2.4 7 5.2
ln P
2.3 ln E
5
2.2 6

4.8
2.1
5
2 4.6
1.9
4 4.4
1.8

1.7 4.2
3
1.6
4
1.5 2
3.8
1.4

1.3 1 3.6
80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02 80 82 84 86 88 90 92 94 96 98 00 02

(a) ln YtGER . (b) ln PtGER (solid line) (c) ItGER .

and ln EtGER .

Fig. 4. Logarithmic time series for Germany.

Table 1
Unit root test statistics.
GER US UK
Time series nl z(t) t-statistic nl z(t) t-statistic nl z(t) t-statistic
ln Y 1 (1) -1.49 1 (1) -1.19 0 (1) -0.83
ln P 1 (1,t) -1.86 0 (1,t) -1.99 0 (1,t) -3.10
ln E 0 (1,t) -2.29 1 (1,t) -1.97 0 (1,t) -1.90
∆ ln Y 0 (0) -7.47∗∗∗ 0 (0) -9.14∗∗∗ 0 (0) -8.51∗∗∗
∆ ln P 0 (1) -8.79∗∗∗ 0 (1) -9.09∗∗∗ 0 (1) -9.85∗∗∗
∆ ln E 0 (1) -7.10∗∗∗ 0 (1) -4.86∗∗∗ 0 (1) -7.80∗∗∗
ln I 0 (1) -3.86∗∗∗ 0 (1) -3.03∗∗ 0 (1) -3.61∗∗∗
***, ** and * indicate the rejection of the unit root null with 1%, 5% and 10%
significance level.

The results of the unit root tests in Table 1 are very similar across the markets.
The log bond yield, log stock price index and log earnings are non-stationary
and their first differences are stationary. Moreover, the indicator, ln I, is sta-
tionary implying co-integration between the time series.

4 Statistical analysis of the Fed model

To test the predictive ability of the indicator, we estimate a Vector Equilib-

rium Correction (VEqC) model popularized by Engle and Granger (1987) and

5
Johansen (1995) for the vector process
 
 ln Yt 
 
xt =  
 ln Pt  .
 
 
ln Et

This approach is similar to the Vector autoregression (VAR) approach used in

Campbell and Shiller (1988), and it has similar advantages. A VEqC model
is obtained from a VAR model by adding an “equilibrium correction” term to
it. It is a linear time series model of the form
k
X
∆xt = c + Ai ∆xt−i + α(β 0 xt−1 − µ) + ²t , ²t ∼ N (0, Σ), (2)
i=1

where c ∈ R3 , Ai ∈ R3×3 β ∈ R3×l , µ ∈ Rl , α ∈ R3×l and Σ ∈ R3×3 is

the covariance matrix for the normally distributed random innovations. The
third term on the right takes into account the long-term behavior of xt around
statistical equilibria described by the linear equations β 0 x = µ. It is assumed
that, in the long run,
E[β 0 xt ] = µ, (3)
and that if xt deviates from the equilibria (due to shocks in economic condi-
tions) it will tend to move back to them. The matrix α determines the speed
of adjustment towards the equilibria. In this sense, VEqC-models incorporate
long-run equilibrium relationships (often derived from economic theory) with
short-run dynamic characteristics deduced from historical data.

We are interested in whether or not the indicator It could serve as an equilib-

rium term in a VEqC-model for xt , and whether it explains the variations in xt ,
and particularly on Pt as the Fed model stipulates. This can be studied by the
method of Engle and Granger (1987) which entails choosing β 0 = [1, −1, 1] and
estimating the remaining parameters of (2) from historical data. The resulting
parameter estimates after recursively deleting all the insignificant regressors
at the 5% significance level and the corresponding t-values (in parenthesis)
are given in Tables 2 – 4 for the three markets.

The results show that the indicator It has a statistically significant negative
effect on the equity prices in all the three countries, as the Fed model pos-
tulates. In fact, the indicator It is the only significant regressor for the stock
price in every market. The indicator also has a positive effect on earnings in
all the markets.

The lagged log changes in earnings seem to explain the changes in log earn-
ings across the markets. None of the variables in the model can explain the
changes in the log bond yields in the US and UK. In Germany the bond yield

6
Table 2
Parameter estimates for the United States.
Constant ∆ ln Yt−1 ∆ ln Pt−1 ∆ ln Et−1 ln It−1

∆ ln Yt
∆ ln Pt 0.736 -0.147
(2.56) (-2.45)
∆ ln Et -0.198 -0.077 0.520 0.044
(-2.27) (-2.01) (5.62) (2.04)

Table 3
Parameter estimates for the United Kingdom.
Constant ∆ ln Yt−1 ∆ ln Pt−1 ∆ ln Et−1 ln It−1

∆ ln Yt
∆ ln Pt 0.872 -0.176
(2.46) (-2.35)
∆ ln Et -0.384 0.195 0.082
(-2.30) (2.53) (2.37)

Table 4
Parameter estimates for Germany.
Constant ∆ ln Yt−1 ∆ ln Pt−1 ∆ ln Et−1 ln It−1

∆ ln Yt 0.584 0.285 -0.124

(3.33) (2.84) (-3.35)
∆ ln Pt 0.630 -0.127
(2.38) (-2.22)
∆ ln Et -0.594 0.220 0.128
(-2.34) (2.08) (2.39)

differences are autocorrelated and also affected by the indicator. The residual
test statistics are shown in Tables 5 – 7 for the United States, United King-
dom and Germany, respectively. In the US data there is slight autocorrelation
and normality problems in the residuals of ∆ ln Y and ∆ ln P , respectively,
but none of the tests are rejected at the 1% significance level, so the model
seems to be correctly specified. In the UK and German data the normality as-
sumption is rejected for ∆ ln E and ∆ ln P , respectively at the 1% significance
level.

7
Table 5
Equation residual diagnostics for the US
Equation AR 1-5 F Norm χ2 ARCH 4 F HET F

∆ ln Y 0.037 0.296 0.341 0.907

∆ ln P 0.480 0.044 0.924 0.082
∆ ln E 0.878 0.538 0.764 0.963
Note: In Tables 5– 7 the numbers are p-values of the statistics in the first row.

Table 6
Equation residual diagnostics for the UK
Equation AR 1-5 F Norm χ2 ARCH 4 F HET F

∆ ln Y 0.272 0.206 0.533 0.824

∆ ln P 0.202 0.016 0.714 0.001
∆ ln E 0.217 0.000 0.844 0.993

Table 7
Equation residual diagnostics for the Germany
Equation AR 1-5 F Norm χ2 ARCH 4 F HET F

∆ ln Y 0.695 0.400 0.676 0.786

∆ ln P 0.144 0.000 0.832 0.099
∆ ln E 0.102 0.015 0.065 0.279

5 Forecast tests with the Fed model

We write the model as

k
X
∆d xt = Ai ∆d xt−i + α(β 0 xt−1 − µ) + ²t , ²t ∼ N (0, Σ), (4)
i=1

where ∆d denotes the shifted difference operator

∆d xt := ∆xt − d

with d ∈ R3 ; see also Clements and Hendry (1998, p. 160). This format is
convenient since the parameter vector d determines the average drift in simu-
lations. If ∆d xt is stationary, (4) gives
à k !
X
E[∆d xt ] = Ai E[∆d xt ],
i=1

8
so if (4) is free of unit roots, E[∆d xt ] = 0, or

E[∆xt ] = d. (5)

The data, might suggest that there is a strong negative drift in the bond yield.
However, we believe that E[∆Yt ] = 0 in the long run, so we choose dY = 0
rather than estimating it from the data. The P/E-ratio satisfies

∆ ln(Pt /Et ) = ∆ ln Pt − ∆ ln Et = ∆d ln Pt − ∆d ln Et + dP − dE ,

so if ∆d ln Dt and ∆d ln St follow (4), and if (4) is stationary,

E[∆ ln(Pt /Et )] = dP − dE .

Since there is no reason to believe that the P/E-ratio would have a consistent
drift, one way or the other, we assume dE = dP . Thus
 
0
 
 
d = dP  . (6)
 
 
dP

We build the model by first choosing a drift parameter d and then estimate
the remaining parameters A and α from the data.
1-step LnP
1-step LnP Forecast
Forecast

7 7

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
1-step LnE 1-step LnE
Forecast Forecast
3.8 3.8

3.6 3.6

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
2 2 1-step LnBy
1-step LnBy Forecast
Forecast

1.5 1.5

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003

(a) VEqC. (b) VAR

Fig. 5. Out of Sample Forecasts for the US.

5.1 Estimation results

The estimation period was 1980/1–2000/1. The period 2000/2-2003/4 was

reserved for the out-of-sample tests. The value of the parameter dP is the

9
 1-step LnP 8.5 1-step LnP
8.5 Forecast Forecast

8.25
8
8

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
1-step LnE 5.4 1-step LnE
Forecast Forecast

5.2
5.2

5
1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
1.8 1-step LnBy 1.8 1-step LnBy
Forecast Forecast

1.6 1.6

1.4 1.4

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003

(a) VEqC. (b) VAR

Fig. 6. Out of Sample Forecasts for the UK.

1-step LnP
7 Forecast 7 1-step LnP
Forecast

6.5 6.5

6 6

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
1-step LnE
4 1-step LnE
4 Forecast Forecast

3.75 3.75

3.5
3.5

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003
1-step LnBy
1.8 1-step LnBy
1.8
Forecast Forecast

1.6
1.6
1.4

1999 2000 2001 2002 2003 1999 2000 2001 2002 2003

(a) VEqC. (b) VAR

Fig. 7. Out of Sample Forecasts for Germany.

1 1 1

0.8 0.8 0.8

0.6 0.6 0.6

0.4 0.4 0.4

0.2 0.2 0.2

0 0 0

-0.2 -0.2 -0.2

-0.4 -0.4 -0.4

-0.6 -0.6 -0.6

-0.8 -0.8 -0.8

-1 -1 -1
82 84 86 88 90 92 94 96 98 00 02 82 84 86 88 90 92 94 96 98 00 02 82 84 86 88 90 92 94 96 98 00 02

(a) United States. (b) United Kingdom (c) Germany

Fig. 8. Correlations between ∆ ln S and ∆ ln Y , 1982-2003.

maximum likelihood estimate computed from historical data. The estimated

values are dUP S =0.019, dUP K = 0.02 and dGER
P = 0.0224, for the US, UK and
Germany, respectively.

10
5.2 Forecast performance

We tested the VEqC-models in out-of-sample tests against VAR-models for

differences. The VAR-models were obtained by dropping the equilibrium cor-
rection term (the FED-indicator) and re-estimating the remaining parameters
from the data. The results appear in Figures 5–7. At least in the US, the
VEqC-model with the indicator seems to outperform the simpler VAR-model
in forecasting the stock price index. For the other countries the results do
not clearly favor the VEqC-model. The biggest reason for this seems to be
the rapid change in correlations between the stock returns and log changes
in bond yields during the forecast period, see Figure 8. Figure 8 displays the
two year moving correlation between the log changes in stock prices and bond
yields over time in the three countries from 1982/1 to 2003/1. The Figures
indicate that the correlation has been clearly negative in all the markets most
of the time. However, after the stock market crashes of 1987 and 2000 the
correlations have rapidly turned positive and during the last few years the
correlation has been very high in all the three markets.

6 Conclusion

The Fed model and the related bond-stock yield difference models in Ziemba
and Schwartz (1991) and Berge and Ziemba (2003) do have some predictive
power related to future crashes and price rises. Berge and Ziemba (2003) pro-
vide specific tests of trading rules and Ziemba (2003) has pictures of leading
crashes such as 1987 in the US and Japan, 1990 in Japan and 2000 to 2003
in the US. These results are consistent with the results here. The VEqC and
VAR models are useful to model this phenomenon. The VEqC model has the
advantage over VAR, that it can incorporate long-run equilibrium relation-
ships derived from economic theory with short-run dynamic characteristics
deduced from historical data. As in Berge and Ziemba (2003) the predictive
results are better in the US than in the other countries. The models are better
in predicting crashes than for subsequent stock price rises.

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