I think the best analogies to current stock market behavior can be found in the federal reserve rate cutting cycles during the 1950s and the 1960s. These were time periods of increasing inflation and very favorable earnings yields on the stock market using the fed model.
After a 20% market drop from July to October 1957, the federal reserve stopped raising interest rates on October 1, 1957 when the fed funds rate was 3.5%. The fed then started cutting interest rates in November 1957 and continued cutting them until July of 1958 when the effective fed funds rate was 0.68%. During this time period, the stock market stayed in a trading range from October 1958 through March 1959 and then began an upward rally of over 50% which ended in July of 1959. The earnings yield on the S&P 500 during this time period was about 6% and the 10-year T-Bond yield was around 4%.
The federal reserve raised the effective fed funds rate back up to 4% by November 1959 and kept it between 3.8% and 4% until after May 1960. The stock market dropped close to 15% during this time period. The federal reserve started lowering interest rates in June and the S&P stayed in a trading range until October when the federal reserve dropped interest rates to 2.5% and a rally began. The S&P 500 increased by around 40% between October 1960 and January 1962. The fed continued to cut interest rates to 1.2% by July 1961. The earnings yield was about 5% on the S&P 500 during this time period and the 10-year T-Bond yield was around 4%.
By November 1966 the federal reserve had raised the fed funds rate back up to around 5.75%. After a 20% market drop between January and October 1966, the federal reserve again stared cutting rates. The federal reserve cut interest rates to below 4% by May 1967. The S&P 500 rallied by around 35% between October 1966 and October 1967. The earnings yield on the S&P 500 was around 5.5% during this time period and the T-Bond yield was around 5%.
Stock market volatility seems lower today then it was in the 1950s. Since we have not had a market drop in excess of 20% this year it seems unlikely that a 40% market increase will occur in 2008, but history tends to repeat itself which indicates that 2008 could be a pretty good year for the stock market. One could argue that an additional 10% down side is possible, but no significantly lower market bottoms occurred after the fed started cutting interest rates during the rate easing periods discussed above. As of yet the fed has not decreased rates during this cycle as much as it did during the 50s, and 60s, but $500 billion is a lot of liquidity.