Intuitively, it seems that financial stress should be related to risk premium: the higher financial stress, the higher risk premium. After plotting the two items together, I checked and found no meaningful mathematical relationship. However, looking at them together, there are a number of observations that may be useful.
Note the two items are not expressed in the same units: risk premium is in % while the St. Louis Financial Stress Index is in standard deviations.
Defining a Bubble
From 1999 to 2002 the risk premium was negative, which I interpret to mean stocks were in a bubble for quite a while, even after the techs started to return to earth.
From the middle of 2003 until the middle of 2007 financial stress stayed in negative territory, meaning it was lower than average. The risk premium bobbed around in a range that averages out to 1.6%. Those were the days of the Greenspan Put, when the maestro had your back and conditions were calm and generally favorable.
When the Financial Crisis struck, financial stress went through the roof, taking the risk premium with it. As the situation improved, they went down in tandem.
When the European Crisis hit, it ignited fear of contagion that proved to be irrational. At that point the US financial system had been stabilized and financial stress here was in a manageable area throughout, thanks in good measure to the Fed's consistent easy money stance.
As financial stress has gone below zero and stayed there, the risk premium has been coming down steeply, manifesting in higher stock prices. That raises the question, how much further can it go?
More Halcyon Days?
It doesn't take a very active imagination to extend the lines into 2014, with financial stress getting down below minus 1 and risk premium settling in a range around its average of 2%, or perhaps as low as the 1.6% mentioned above.
There is beginning to be some speculation that the 10 year yield may not rise as rapidly as some expect. The argument would be, how much risk free debt is there, compared to what we thought we had in 2007? Meanwhile, demand is higher. So the laws of supply and demand may keep the 10 year below its historical average in the area of 4.4%.
China could be the wild card here. The country has an extraordinary amount of bad debt that is not being dealt with. There have been the usual tremors that precede a major earthquake. Their wealthy have been leaving in record numbers, taking their money with them, as much as possible. That's very similar to how the wealthy behaved in Greece, they all bought properties in expensive areas of the UK, and moved their money offshore.
I don't have a strong opinion. The Chinese situation will most likely unwind in a way that leaves the Central Government holding the bag in the form of a heavy debt load. That's what happened here. After re-enacting the Perils of Pauline over the European situation, the US equity markets may not over-react to a Chinese financial crisis. Debt of the US Government will remain in demand, especially as the budget deficit evaporates in the hot sun of a recovering economy.