On Monday, Federal Reserve Governor Lisa Cook delivered a blunt warning about the stock market, stating that valuations are elevated and susceptible to large declines. This warning is reminiscent of former Chair Alan Greenspan’s 1996 warning of "irrational exuberance."
Cook’s Warning: Valuations Are Elevated
Valuations are indeed elevated in many asset classes, including equities and corporate debt markets. According to Cook, estimated risk premia are near the bottom of their historical distributions, suggesting that markets may be priced to perfection and susceptible to large declines.
Market Response: Ignoring the Warning
Despite Cook’s warning, the stock market seemed to ignore it. The S&P 500 recaptured the 6,000 level as it neared record highs on Monday, with stocks later trimming gains but still ending with a gain of 0.6%. The New York Fed’s corporate-bond-market distress index was also at a historically low level.
Why Valuations Are a Concern
The S&P 500 last year registered its second straight gain of at least 20%, according to Goldman Sachs. Relative to its book value and sales, the S&P 500 is two standard deviations above the average of the last 10 years. Economist Robert Shiller’s cyclically adjusted price-to-equity ratio (CAPE) is around 37, which is near the highest level since the dot-com bubble burst.
The CAPE Ratio: A Long-Term Measure
The CAPE ratio measures the price of the S&P 500 divided by average corporate earnings over the previous decade. Proponents argue that it smooths out cyclical variations and gives a better view of where valuations stand versus history. However, it’s not seen as very useful for timing market tops.
Historical Precedent: Greenspan’s Warning
Former Chair Alan Greenspan delivered a warning in December 1996 about the stock market being "irrational exuberance." While this caused global markets to wobble, it didn’t mark the end of the dot-com-fueled rally. Art Hogan, chief market strategist at B. Riley Wealth, noted that Greenspan was four years early in making his call.
Current Market Conditions: A Broadening Rally
Five of the S&P 500’s 11 sectors ended 2024 outperforming the broader index, indicating a broadening rally beyond the Magnificent Seven megacap tech stocks. This could alleviate valuation worries, according to Hogan.
Investor Sentiment: Artificial Intelligence and Deregulation
Investors are reacting to developments in artificial intelligence amid hopes for deregulation under a second Trump administration. Stretched valuations come as investors cling to cash, which could lead to losses if the debt-ceiling fight escalates.
Wall Street Strategists’ Expectations
Virtually every Wall Street strategist expects the stock market to rise. Even the rare analyst who expects the market to fall, like Stifel’s Barry Bannister, says it would take something besides valuation – such as a deterioration in the economy – for the market to correct.
Earnings Season: A Test of Valuations
Fourth-quarter earnings season will start next week, and investors will be looking for earnings growth to support present valuations. Consensus for 2025 EPS growth is close to 15%, which is more than double the historical average. If earnings season offers any red flags on expectations, especially from megacap tech names, it’ll amplify concerns on valuations.
Conclusion
Federal Reserve Governor Lisa Cook’s warning about large stock market declines should be taken seriously. Valuations are indeed elevated, and a deterioration in fundamentals could leave the market vulnerable. While investor sentiment remains bullish, earnings season will provide a test of valuations. It’s essential for investors to remain cautious and not ignore Cook’s warning.
References:
- Goldman Sachs: S&P 500 valuation metrics
- Robert Shiller’s CAPE ratio
- Art Hogan, chief market strategist at B. Riley Wealth
- Kevin Simpson, CEO of Capital Wealth Planning
- William Watts contributed to this article
