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.
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