The FSVM is missing a variable reflecting that the forward earnings yield is riskier than
the government bond yield. How should we measure risk in the model? An obvious
choice is to use the spread between corporate bond yields and Treasury bond yields. This
spread measures the market’s assessment of the risk that some corporations might be
forced to default on their bonds. Of course, such events are very unusual, especially for
companies included in the S&P 500. However, the spread is only likely to widen during
periods of economic distress, when bond investors tend to worry that profits won’t be
sufficient to meet the debt-servicing obligations......