The Stock Market Sounds an Alarm as Investors Get a Warning From the Federal Reserve. History Says This Could Happen Next.

The S&P 500 (SNPINDEX: ^GSPC) is generally considered the best benchmark for the entire U.S. stock market. The index has underperformed the global market (excluding U.S. stocks) by its widest margin year to date since 1995, and a recent warning from the Federal Reserve explains why: U.S. equity valuations are near the upper end of their historical range.

Here's what investors should know.

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The Federal Reserve warns investors that U.S. stocks are expensive

The Federal Reserve does not set monetary policy with specific asset prices in mind, nor do policymakers claim to know what the appropriate price might be for any specific asset. But Fed Chairman Jerome Powell warned in September, "Equity prices are fairly highly valued."

The minutes from the January Federal Open Market Committee (FOMC) meeting held another warning. "Several participants commented on high asset valuations and historically low credit spreads." The spread (extra yield) between investment-grade corporate bonds and U.S. Treasuries of corresponding maturities hit 71 basis points (0.71%) in late January, its lowest level since the dot-com bubble in 1998.

What does that mean? Investors are receiving very little additional compensation for purchasing high-quality corporate bonds as compared to what they would receive from U.S. Treasuries, which are considered risk-free. That signals great confidence in the companies issuing investment-grade bonds. However, there is a fine line between confidence and complacency.

It signaled complacency in 1998. Investors were overly confident in many technology companies involved in the internet boom. Today, investors are very confident in technology companies involved in the artificial intelligence (AI) boom. That does not mean stocks are in a bubble akin to the dot-com bubble, but the S&P 500 is certainly expensive by historical standards.

Minutes from the January FOMC meeting highlighted that vulnerability. "The staff judged that asset valuation pressures were elevated. Price-to-earnings ratios for public equities stood at the upper end of their historical distribution."

History says the S&P 500 may be headed for a bear market

The S&P 500 has more or less maintained a forward price-to-earnings (P/E) ratio above 22 since July 2025. That is well above the 10-year average of 18.8 times forward earnings. In fact, the index has only sustained a forward P/E ratio above 22 during two periods in the last four decades. Both incidents ultimately led to bear markets, as detailed below:

• Dot-com bubble: The S&P 500's forward P/E ratio exceeded 22 in 1998 and peaked above 24 in 1999 as investors piled into technology stocks involved in the internet boom, many of which were unprofitable start-ups that lacked sustainable business models. By late 2002, the index had fallen 49% from its high as the reality of the situation became apparent.
• COVID-19 pandemic: The S&P 500's forward P/E ratio rocketed by 22 and peaked above 23 in 2020 as investors failed to appreciate how hard the pandemic would hit businesses. By late 2022, the index had declined 25% from its record high as the Federal Reserve raised interest rates rapidly to curb the worst inflation in four decades.

What should investors know today? Stocks are historically expensive, and credit spreads are historically tight. That does not mean a bear market is inevitable, but the environment does warrant caution. If the economic outlook deteriorates and credit spreads widen, companies would have to pay more to borrow money, which would cut into profits.

In that scenario, earnings would grow more slowly than Wall Street expects, which could cause a steep decline in stocks because the S&P 500 is already expensive, even when forward earnings estimates are factored into the valuation. That does not mean you should sell your entire portfolio. However, it makes sense to focus on high-conviction stocks (those whose earnings are likely to be much higher in five years), provided they trade at reasonable prices.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.