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Disclaimer: Originally I asked this question on the personal finance site (see here) where it was (rightfully) closed since it does not directly relate to personal finance but is rather a general economics question.

From the answers to my earlier question I learned that the expected return on the stock market is positively correlated with the interest level at the beginning of the considered time period. The reason is that otherwise the Efficient Market Hypothesis would be contradicted since the expected return is the risk-free rate plus a risk premium (the higher the risk the higher the premium).

Now I am wondering if this could be used to validate the Efficient Market Hypothesis empirically: A bit oversimplified, one could look at the stock market performance in all years where the the risk free interest rate was 5% at the beginning of that year and compare the average performance to the average performance of all years where the risk free interest rate was 1% at the beginning of the year. If the Efficient Market Hypothesis holds in practice, then the former should be significantly higher than the latter (or the volatility of the stock market is negatively correlated to the interest rate, so to make this analysis more precise one would have to account for effects on the volatility, too).

Has it been analyzed whether the interest rate at the beginning of the considered time period and the development of the nominal performance of the stock market are positively correlated empirically? Would this approach be suitable to analyze the empirical applicability of the Efficient Market Hypothesis?

Edit: I just found this very similar question which describes essentially the same considerations. I think the difference between both questions is small, but the focus of my question is slightly different: I want to understand whether the Efficient Market Hypothesis is considered to be (more or less) true in practice and whether the described considerations are suitable in order to validate the Efficient Market Hypothesis. Therefore, in this question, the relation between the interest rate and the stock market performance is mostly considered as a way to validate the Efficient Market Hypothesis.

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Yes, this has been studied. The seminal work is Robert J. Shiller, "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?", published in the American Economic Review in 1981. He won the Nobel Prize in 2013 in large part for his work testing the efficient markets hypothesis.

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  • $\begingroup$ That paper does not study the effect of interest rates $\endgroup$
    – 1muflon1
    Jun 7, 2023 at 8:58

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