Yield gap models and equity allocations

The yield gap model is an important tool for determining valuation in  equities. You just have to look at the yield on a long-term Treasury versus the earnings yield of a stock index. There have been problems with this type of model,  but it generally works as a good simple pass on the data. If the earnings yield is higher than bond yields buy equities. If bond yields are higher than earnings yield buy debt. If the yield gap gets larger, then hold less equity. This allocation can be mapped into a set of equity and bond weights.

A simple problem with this simple model is that is does not account for the yield curve. You are not accounting for the price of money through time. We know that the yield curve tells us a lot about the economy. An inverted yield curve will usually precede a recession. The yield gap in a short-term rate can be compared with the yield gap of a long-term rate. If there is a significant difference between the two, it tells us that there is a difference in the shape of the yield curve. This can be used as an added signal for determining the market allocation. This type of model is used at BlackRock.

Of course, it could be used separately as a two part or dual model of yield gap and yield curve instead of a combination of two yield gap models which switches based on the difference between the yield gap model. The yield gap or Fed-type models have had a mixed history, but still seems to be an easy way to provide a first pass at relative value that can be employed by most investors.