Zinger Key Points
- The equity risk premium has turned negative, reaching levels last seen during the dot-com bubble.
- Ed Yardeni sees the S&P 500 hitting 7,000 by year-end, citing strong earnings and potential Federal Reserve rate cuts.
- Get the Real Story Behind Every Major Earnings Report
Imagine you could park your money in a 10-year U.S. Treasury bond and earn a safe 4.65% annual return. Now, compare that to the S&P 500, where the forward earnings yield sits at 3.9%, meaning stocks aren't offering any extra compensation for their risk.
What would you choose?
This rare market dynamic is raising eyebrows on Wall Street, as one of the most-watched valuation measures—the equity risk premium—has turned negative, hitting levels last seen at the heights of the dot-com bubble.
A piece published Friday by the Financial Times is sparking debates among financial experts about whether this signals a major red flag for U.S. equity valuations.
While some argue stocks remain extremely overvalued, others actually expect echoes of the late 1990s, when a similar scenario preceded a historic bull run.
What Is The Fed Model Saying?
The Federal Reserve model, a widely followed valuation metric introduced by economist Ed Yardeni in 1998, compares the S&P 500's forward earnings yield with the yield on a 10-year Treasury bond. When the difference is positive, stocks appear undervalued relative to bonds; when it's negative, equities could be overpriced.
Right now, with the S&P 500's forward earnings yield at 3.9% and 10-year Treasuries yielding 4.65%, the spread is negative—meaning stocks are more expensive than risk-free bonds on a relative basis.
Analyst Daniel Fang, CFA and CAIA, recently highlighted in a CFA Institute blog post that “the intuition is that stocks and bonds are competing assets; therefore, buying riskier stocks only makes sense when stocks can out-earn risk-free U.S. Treasuries.”
Yet, Fang also highlighted ongoing criticism of the model for its “lack of theoretical foundation.”
Stocks Keep Climbing: Yardeni Eyes S&P 500 At 7,000 By Year End
Despite valuation concerns, U.S. stocks keep pushing to new records. The S&P 500 – as tracked by the SPDR S&P 500 ETF Trust SPY – surged past 6,100 following Donald Trump's inauguration this week, setting fresh all-time highs.
Yardeni, speaking on CNBC on Thursday, stood by his bullish outlook: “I still think [the S&P 500] is going to 7,000 by end of the year. That's probably the highest on the Street in terms of what the S&P 500 can accomplish, and thinking maybe that number's conservative or maybe I'll raise it because so far, it looks like the fourth quarter of 2024 is coming in better than expected.”
He now expects fourth-quarter earnings to rise 12% year-over-year, adding that concerns about bond yields at 5% “melted away” after a Federal Reserve official suggested rate cuts could exceed two times, potentially three or four cuts in 2025.
Lower rates typically boost stock valuations as they reduce the discount rate applied to future corporate earnings.
Could The Market Repeat The Late ‘90s Rally?
Guilherme Tavares, CEO at i3invest, cheered on the fact that the equity risk premium reached levels similar to 1997.
“Back then, there was a massive three-year rally before the market reached its peak; imagine that! If we apply the same analogy, we could potentially see another strong rally of about 60%,” he wrote on X.
Macro trader Spencer Hakimian, founder of Tolou Capital Management, echoed this perspective in a post published earlier this month.
He highlighted that while the equity risk premium is an important valuation tool, “it's by no means infallible. ERP was negative for basically all of the 1990s. And the 1990s was the best decade for equity returns ever.”
The Bottom Line
The stock market's latest valuation signal is unsettling, but history suggests it may not be an immediate reason for panic.
While bonds currently offer better risk-adjusted returns, the broader market remains bullish, especially with expectations of Federal Reserve rate cuts.
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