(Photo: AP)
After the Federal Reserve raised the federal funds rate as expected on Wednesday, investors are no doubt watching how longer-term interest rates respond. But the stock market's moves will be just as revealing.
U.S. stocks have been on a historic run since the 2008 financial crisis. The S&P 500 Index has returned 18 percent annually from March 2009 through August, including dividends, making it one of the best decades for stocks since 1926. It's also the second-longest stretch without a bear market, as defined by a decline of 20 percent or more.
Bulls attribute much of that success to lower interest rates. It's no coincidence that stocks skyrocketed soon after the Fed dropped rates in late 2008 in response to the financial crisis, they argue, and that the market kept moving higher while the Fed held rates low for years.
The gist of the argument is that investors expect a premium for owning risky stocks rather than safe bonds — in technical jargon, an equity risk premium. When bond yields decline, stocks can pay less, too, provided that the premium stays roughly the same. But there's little evidence investors are paying attention to the premium.
One way to measure the equity risk premium is by comparing the market's earnings yield — the ratio of stocks' earnings to their market value — with the yield on bonds. For example, the S&P 500 hit bottom on March 9, 2009, with a closing price of 676.53, and analysts expected earnings per share for the index of $60.87 over the next 12 months. That translated into an earnings yield of 9 percent, or an equity risk premium of 6.2 percent over the 10-year Treasury yield of 2.8 percent at the time.
It was a huge premium in historical terms. The S&P 500 had returned 9.3 percent a year from 1926 to February 2009, while long-term government bonds had returned 5.5 percent — an equity risk premium of 3.8 percent.
