The Fed vs. Stock Market Reality

Federal Reserve Governor Lisa Cook issued a stark warning on Monday about risks in the financial market, delivering one of the most candid assessments from a central bank official in recent years. Cook stated that “valuations are elevated in a number of asset classes, including equity and corporate debt markets, where estimated risk premia are near the bottom of their historical distributions.” This, she cautioned, suggests markets may be “priced to perfection” and thus highly susceptible to significant declines in response to bad economic news or shifts in investor sentiment.

Cook’s comments drew comparisons to former Fed Chair Alan Greenspan’s 1996 warning about “irrational exuberance,” a phrase that famously highlighted speculative market behavior. Unlike Greenspan’s remarks, which caused immediate volatility in global markets, Cook’s warning seemed to fall on deaf ears. The S&P 500 briefly surged past 6,000, nearing record highs, and closed the session up 0.6%, despite trimming some of its earlier gains.

Market indicators further illustrate the current lack of investor caution. The New York Fed’s corporate-bond-market distress index remains at historically low levels, and the S&P 500 has logged two consecutive years of gains exceeding 20%. According to Goldman Sachs, the index’s price-to-book and price-to-sales ratios are two standard deviations above their 10-year averages. Meanwhile, economist Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, a long-term valuation metric, stands near 37—levels not seen since the dot-com bubble.

While such metrics signal overvaluation, they offer little predictive power for market timing. Greenspan’s 1996 warning, for instance, did not halt the dot-com boom, which continued until early 2000. This historical precedent may explain why investors remain largely unfazed by Cook’s remarks.

“Greenspan wasn’t wrong, but he was four years early,” said Art Hogan, chief market strategist at B. Riley Wealth. “Since then, Fed officials have generally avoided direct commentary on valuations.”

Despite concerns about stretched valuations, market sentiment remains buoyant. Five of the S&P 500’s 11 sectors outperformed the broader index in 2024, suggesting the rally may be broadening beyond the dominance of mega-cap tech stocks—the so-called “Magnificent Seven.” Such diversification could help ease worries about overconcentration in a few high-growth names.

Fueling this optimism are advancements in artificial intelligence and expectations of regulatory rollbacks under a potential second Trump administration. Even so, high valuations leave the market vulnerable to downside risks, particularly if economic fundamentals weaken.

Upcoming corporate earnings reports could provide a key test. “Consensus for 2025 EPS growth is close to 15% — more than double the historical average,” noted Kevin Simpson, CEO of Capital Wealth Planning, in a Monday note. “If earnings season reveals any red flags, especially from mega-cap tech companies, it could amplify concerns about valuations.”

While Wall Street strategists largely expect continued gains, some, like Stifel’s Barry Bannister, believe a correction is more likely to be triggered by an economic downturn or other external shocks rather than valuation concerns alone. Elevated market levels, however, mean that any negative surprise could have outsized consequences.