Historical Parallels: S&P 500’s Current Valuation Echoes Dot-Com Era Before a 50% Crash
US stocks have defied expectations this year, staging a robust rally amid soaring interest rates and recession fears. The surge, fueled by subdued inflation and growing excitement around artificial intelligence, surprised Wall Street. However, recent developments, including the Federal Reserve’s unwavering commitment to higher interest rates and a deepening bond-market downturn, have dampened equity sentiment, prompting a reevaluation of the market.
Insider’s research reveals that stock valuations are reaching precarious levels, heightening the risk of a correction. A concerning indicator is the relative valuation of stocks compared to the debt market. In August, the S&P 500 reached levels reminiscent of the dot-com boom peak concerning an index tracking the US corporate bond market. This trend persists, despite the recent pullback in equities.
This metric last surged to such heights in the spring of 2000, preceding a substantial market downturn where the S&P 500 plummeted by 50% between March 2000 and October 2002. Another signal of richly valued stocks compared to debt is the equity risk premium, representing the additional return on shares over government debt, a traditionally safer investment. This metric has hit historic lows in 2023, indicating elevated stock valuations.
MacroEdge, a research firm, highlights the significance of the equity risk premium nearing its worst level since 1927. They draw parallels between such occurrences and major corrections and recessions, citing instances in 1929, 1969, 1999-2000, 2007, 2018-2019, and the present situation.
Various experts, including Luca Paolini, chief strategist at Pictet Asset Management, have echoed concerns about the equity risk premium. Paolini notes that this metric has reached new cyclical lows, remaining well below historical averages. Despite recent market pullbacks, the stock market appears more expensive relative to the bond market.
Roth MKM analyst Michael Darda supports this viewpoint, emphasizing the stock market’s increased costliness compared to bonds. Darda notes that the equity risk premium, calculated as earnings yield minus bond yield, is at a new cycle low, underscoring the market’s overvaluation.
Billionaire investor Jeffrey Gundlach, CEO of DoubleLine Capital, adds to the chorus of concerns. He deems stocks excessively priced and anticipates a recession in the US within the next three quarters. Gundlach cites the market’s overvaluation, with the risk premium at its lowest in 17 years, as a compelling reason to approach equities with caution.
As Wall Street grapples with these signals, investors are left to navigate a complex landscape where the once-unstoppable rally faces headwinds, and the specter of a correction looms large.