Wall Street is celebrating as the Federal Reserve’s half-point rate cut triggers a market rally, but the cheers are tempered by rising anxieties about inflated valuations. The Fed’s easing stance has sparked optimism, pushing U.S. stocks and commodities higher, and calming volatility in the bond market. The Nasdaq 100, in particular, has enjoyed its most significant two-week surge since November, dispelling worries that the Fed chair had delayed ending its two-year battle against inflation.
However, the specter of inflated valuations looms large, leaving little room for error if any event throws a wrench into investors’ ambitious bets. According to Bloomberg, a model analyzing S&P 500 earnings yields and 10-year Treasury rates adjusted for inflation suggests current cross-asset pricing is at a higher level than at the start of all previous 14 Fed easing cycles, which are typically linked to recessions. This suggests that the market might be getting ahead of itself.
Lauren Goodwin, economist and chief market strategist at New York Life Investments, cautions that while high prices are only one factor in a complex market landscape, they magnify market vulnerability if other issues arise. U.S. stocks have soared, propelling the S&P 500’s total return for 2024 above 20%. The index surged 1.7% on Thursday, marking its 39th record close this year, following the Fed’s rate cut and data indicating resilience in the labor market.
Despite this positive momentum, many stock valuation measures are stretched. Notably, the Buffett indicator, which compares the total market capitalization of U.S. stocks to the nation’s GDP, is hovering near a record high. This is occurring at a time when Warren Buffett himself has recently reduced some of his high-profile equity holdings. While the rally in U.S. stocks is justified by earnings growth keeping pace with high valuations, the potential for disappointment lingers. The Treasury market, where futures trading anticipates more interest rate cuts than Fed policymakers themselves see as likely over the next year, reflects this tension. Ultimately, the market’s current euphoria might be riding on a wave of optimism that could be swept away by unforeseen events. This raises the question: will the current rally continue, or are the inflated valuations poised to burst?
