Stock Market Investors Just Got a Warning From the Federal Reserve. History Says This Will Happen Next.
Key Points
The Federal Reserve recently warned investors that the S&P 500's equity risk premium was near its lowest level since the dot-com bubble.
The S&P 500's low equity risk premium means Treasury bonds are more attractive on a relative basis than they have been in decades.
Three Fed officials wanted to raise interest rates in July, and new rate-hiking cycles have often coincided with stock market corrections.
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The S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) have added 13% and 14%, respectively, this year. The driving force behind those gains has been strong corporate earnings growth, particularly among technology companies.
However, the Federal Open Market Committee recently published the minutes from its July meeting, and they included a warning for investors: The S&P 500's equity risk premium is near its lowest level since the dot-com bubble, which means Treasury bonds are more attractive on a relative basis than they have been for decades.
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History says that could sink the stock market.
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The Federal Reserve warns that the stock market's equity risk premium is near historic lows
Equity risk premiums measure the extra return investors anticipate for purchasing stocks rather than risk-free assets, such as U.S. Treasury bonds. The Federal Reserve calculates the S&P 500's equity risk premium by subtracting the real 10-year Treasury yield from the index's forward earnings yield.
To elaborate, the real 10-year Treasury yield is the nominal yield minus the forecast inflation rate, so it measures the expected increase in purchasing power. And the forward earnings yield is the inverse of the forward price-to-earnings ratio, so it measures forecast earnings (as a percentage) per dollar invested.
Minutes from the Federal Open Market Committee's (FOMC) July meeting state:
The staff judged that asset valuation pressures were elevated. Equity valuations remained high despite some moderation from year-end, supported by AI enthusiasm and strong corporate profits. The equity premium was at a level that has only been lower in recent history during the dot-com bubble.
What does that mean? The Federal Reserve is warning investors that stocks are expensive when compared to real 10-year Treasury yields. Specifically, the excess return investors can expect from owning stocks rather than risk-free Treasury bonds is lower today than it has been since the dot-com bubble.
Additionally, the S&P 500 has maintained an equity risk premium below 2.5% for five straight months. That last happened in May 2002, and the S&P 500 declined 16% over the subsequent year.
Several Federal Reserve officials wanted to raise interest rates at the July meeting
In July, the Personal Consumption Expenditure (PCE) price index, the Fed's preferred inflation gauge, increased 3.7% from the previous year. Inflation now hovers at levels last seen in early 2023, and the FOMC attributed that to three things: President Donald Trump's tariffs, elevated energy prices tied to the Iran war, and demand for artificial intelligence.
The FOMC held interest rates steady at the July meeting even though PCE inflation has now topped the Fed's 2% target for 65 months. However, three officials voted for a quarter-point rate hike, up from zero in June, which itself was a change from April, when one FOMC member actually voted for a quarter-point rate cut.
An increasingly hawkish Fed, coupled with stubborn inflation, has the market convinced that rate hikes are inevitable. CME Group's FedWatch tool, which calculates the probability of future interest rates using pricing data from futures contracts, shows the most likely outcome is a quarter-point hike in September 2026 followed by another quarter-point hike in January 2027.
If the Fed raises rates, it will be the first hike in a new tightening cycle. The stock market has often suffered corrections under those circumstances. In the last 30 years, the S&P 500 and Nasdaq Composite have fallen by an average of 10% and 12%, respectively, at some point during the three-month period following the first rate hike in a new tightening cycle.
However, there is a silver lining for patient investors. The stock market has eventually recouped its losses from every past correction, which means every single one has been a buying opportunity.
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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group. The Motley Fool has a disclosure policy.
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