The calm before the Fed. This afternoon, we’ll know a lot more about how aggressively interest rates are going to rise in the next few months.

With all the talk out there about stocks being bubble priced in anything but a zero-rate world, I went back to the historical math to see just how much room the Fed has to move before shareholders feel the pain.

After all, the S&P 500 feels precarious here at 18X projected earnings . . . and there’s no guarantee that those projections will come true. Wall Street is infamous for setting ambitious targets while simultaneously fretting about obstacles in our way.

But guess what? Bond yields also anticipate projections on where interest rates are going, so there’s a hypothetical component to that end of the investment market as well.

We’re comparing forecast to forecast. And since all the targets are constructed within the same analytic framework (yes, strategists talk to each other), the overall picture provides a pretty good sense of where big money thinks returns and risks line up in the near future.

If earnings fail, odds are high that the Fed will pause interest rates to give Wall Street a chance to recover. They don’t want to cause a recession if they can help it.

And in the meantime, if earnings fail, investors who get disappointed, frustrated or even scared will rotate out of stocks into the relative safety of bonds. Yields will go down in the scenario.

So where are we? Here at 18.1X projected earnings, the S&P 500 carries an implied earnings yield of 5.5%.

That’s roughly 2.5% above 10-year Treasury yields. Going back 20 years, that’s about the average spread. It’s “normal.”

Now “normal” doesn’t mean extremely attractive. The time to back up the truck buying stocks is when the spread is a lot wider than usual, so you make easy money on the reversion to the statistical mean.

In absolute terms, we want to see an earnings yield of 6.5% to 7% to imply a big enough return to compensate investors for the risk.  But this is still on the cheap side of the historical spectrum . . . far from an immediate sell signal.

After all, bond yields are still low, especially in real (inflation-adjusted) terms. They simply don’t offer enough of a return to be worthwhile as anything but a hedge.

History supports this. In the past, whenever the relationship between stocks and bonds was in this zone, the S&P 500 tended to climb about 7% in the following 6 months.

To make stocks truly “neutral” relative to bonds, one of two things needs to happen. Either bond yields need to rise at least another 0.25 percentage point or corporate profits in the coming year need to end up close to 4 percentage points below expectations.

The Fed is essentially goading bond yields to keep climbing, so the first scenario is pretty likely. We’re going to see the spread narrow from that side as bonds get back into position to pay more attractive risk-free returns.

And while earnings targets might be 4 percentage points too high, you can’t tell from the current quarter. If anything, expectations were set 2.4 percentage points too low, raising the  base (and the bar) for the rest of the year to build on.

In theory, earnings and bond yields will track roughly in line with each other, with higher yields boosting bank earnings in particular fast enough to maintain the spread.

Of course nobody has a crystal ball and the market rarely lines up perfectly with what the theories predict. The point is that investors have historically done this math and decided that stocks were worth the risk.

After all, the power of great companies is that they can expand over time . . . and in my experience, they tend to expand a lot more often than they implode.

That’s why the long-term trajectory has made investors a lot of money and continues to do so today. Earnings are up 27% on the S&P 500 over the COVID and post-COVID era. Stocks are up 29%.

Treasury yields, meanwhile, have climbed about 1 percentage point, narrowing the spread in the process and taking a little of the appeal away from stocks.

But it’s a process. In the middle, when earnings were plunging and bonds paid nothing, only the Fed’s largesse kept all markets afloat.

Not All Stocks Are The Same

Now that the free money is gone, history is free to take over again. And never forget: even if the S&P 500 as a whole looks like a buy, a sell or a hold, you don’t need to hold your nose and own stocks that can’t compete.

Just do the basic math, stock by stock. A company that can generate more income per share than one-year Treasury paper will pay you risk free can be a better investment as long as you get in at the right price and reevaluate your holdings from year to year.

You don’t even have to speculate about future growth. Just take the trailing earnings as your base . . . any earnings expansion over the coming year is just a bonus in this scenario.

Historically, with short-term rates so low, that means a lot of stocks are attractive. You can hold your nose and, under the right scenario, pay up to 22X trailing earnings for these stocks.

While the risk is real, odds are good you’ll do better than short-term Treasury debt. The risk-return profile is simply better.

But I have to point out that a lot of stocks fail this test. Apple (AAPL) at 28X trailing earnings has a lot of optimism baked in. Investors are counting on the company to keep growing faster than Treasury yields climb.

For the risk averse, even AAPL is about 25% overvalued. Nobody is forcing you to buy it.

Microsoft (MSFT) is no prize either. If you don’t want to take on any risk, don’t buy until earnings climb significantly or the stock drops 35%.

Amazon (AMZN)? Forget about it. That’s a growth story. You need optimism to opt for that stock over the no-risk safety of Treasury debt.

Johnson & Johnson (JNJ) is right on the line. Even if the company doesn’t grow at all in the coming year, there’s enough value tied up in current cash flow to give investors an edge over short-term government yields.

But Berkshire Hathaway (BRK) looks cheap relative to its ability to provide a big enough return for not a lot of additional risk. There’s a chance Warren Buffett will implode, but it’s pretty small.

The banks carry extreme earnings yields. JP Morgan (JPM) trades at a P/E of around 8X trailing earnings . . . an effective yield 10 percentage points above one-year Treasury paper.

Citi (C) is even better on this basis. The stocks might go nowhere. They might even go down. But there’s more room for them to outperform in a no-growth world than anything Big Tech can offer.

We like Big Tech because it’s dynamic. The stocks can grow into their projected prices and take present-day shareholders along with them.

In a market that appreciates a little risk and can wait around a few years, that’s a great proposition. Here, however, the premiums revolve around safety.