On Monday, Federal Reserve Governor Lisa Cook delivered a blunt warning to the stock market, stating that it could see a large decline due to elevated valuations and potential changes in investor sentiment.
Valuations at All-Time Highs
Cook’s remarks were reminiscent of former Chair Alan Greenspan’s 1996 warning of "irrational exuberance," but unlike Greenspan’s comments, Cook’s warnings were largely ignored by the market. The S&P 500 recaptured the 6,000 level as it neared record highs on Monday, with stocks trimming gains but still ending with a gain of 0.6%.
High Valuations a Concern
The New York Fed’s corporate-bond-market distress index was at a historically low level, indicating that stock market valuations are high by historical standards. The S&P 500 last year registered its second straight gain of at least 20%, and according to Goldman Sachs, the S&P 500 is two standard deviations above the average of the last 10 years when measured relative to its book value and sales.
Economic Indicators Suggest a Bubble
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 measures the price of the S&P 500 divided by average corporate earnings over the previous decade and provides a long-term view of valuations.
Why Investors May be Ignoring the Warning
Despite Cook’s warning, investors may be ignoring it due to various factors. Some believe that the market is not yet at a peak and that there are still opportunities for growth. Others may be concerned about the potential impact of regulatory changes on the market.
A Different Perspective from Art Hogan
Art Hogan, chief market strategist at B. Riley Wealth, said, "Greenspan wasn’t wrong but he was four years early in making that call. It seems from that point forward, officials have tried to stay away from valuation commentary."
Five Sectors Outperform the Broader Index
Five of the S&P 500’s 11 sectors ended 2024 outperforming the broader index, indicating that the rally has started to broaden out from the so-called Magnificent Seven megacap tech stocks. This could help alleviate valuation worries.
Wall Street Strategists Expect a Rise in the Market
Virtually every Wall Street strategist expects the stock market to rise, with many citing the potential for earnings growth and deregulation under a second Trump administration as drivers of the market’s upward trajectory.
The Rare Analyst Who Expects a Fall
However, not everyone is optimistic about the market. Stifel’s Barry Bannister expects the market to fall, but believes that it would take something besides valuation – such as a deterioration in the economy – for the market to correct.
Earnings Season Could be Key
Fourth-quarter earnings season will start next week, and investors will be looking for earnings growth to support present valuations. If earnings are lower than expected, it could amplify concerns about valuations.
Consensus Expectations
The consensus for 2025 EPS growth is close to 15%, which is more than double the historical average. However, if expectations are not met, it could lead to a decline in the market.
Conclusion
Cook’s warning was a stark reminder of the potential risks facing the stock market. While investors may be ignoring the warning, it is essential to consider the long-term implications of high valuations and the potential for changes in investor sentiment. As earnings season approaches, it will be crucial to monitor the market’s reaction to any red flags on expectations.