A warning has emerged that risk signals comparable to those preceding the dot-com bubble's collapse are flashing beneath the surface of US markets, even as Wall Street continues its record-setting rally.
The fixed yield available from holding safe-haven US Treasuries is rapidly closing in on the future returns expected from equities, causing the relative appeal of stocks to shrink quickly.
The Wall Street Journal reported on Thursday that the gap between the S&P 500's earnings yield — calculated by dividing corporate earnings by share price, the inverse of the price-to-earnings ratio — and the 10-year US Treasury yield has narrowed sharply in recent weeks.
Stocks typically offer higher expected returns than government bonds because of their greater volatility. The virtual disappearance of this gap means that holding Treasuries, which carry almost no risk of principal loss, has become as reasonable a choice as bearing the volatility of stock investments. Many experts read this narrowing gap as a clear warning sign, given that during the dot-com bubble, stock yields had actually fallen below Treasury yields.
The key driver is the surge in Treasury yields. International oil prices have jumped roughly 60% this year following the Strait of Hormuz blockade and the fallout from the Middle East war, reigniting inflation concerns and rapidly dampening expectations for rate cuts by the US Federal Reserve.
As investors sold off bonds, the 10-year US Treasury yield soared from around 3.96% in late February, just before the strike on Iran, to a recent 4.57%.
Equities, by contrast, kept climbing on the artificial intelligence (AI) frenzy and a tech-stock rally. When share prices rise, earnings yields naturally fall, creating a structure in which the relative appeal of stocks compared with Treasuries has diminished.
"There is currently a disconnect between the bond market and the stock market," said Don Calcagni, chief investment officer at Mercer Advisors. "It's a sign that stock valuations are excessively inflated amid growing inflation fears."
Skepticism is also mounting toward AI, the engine of the rally. Current share prices already reflect expectations that AI investment will translate into corporate productivity and earnings growth, but debate continues over whether actual results will back that up.
"To justify current stock prices, this level of earnings growth would have to continue for years," Calcagni said. "Frankly, that's nearly impossible." Adding to overheating concerns is the spillover of the AI-related tech rally into speculative assets such as quantum computing and space companies.
Optimism remains alive. "Stocks aren't cheap, but they aren't outrageously expensive either," said Jeff Blazek, co-chief investment officer of multi-asset at Neuberger Berman. "Our team expects the Fed to pursue a more accommodative rate policy than the market anticipates."
Even optimists, however, point to the resolution of Middle East geopolitical risk as a precondition for a second-half rally. "My colleagues and I have started calling oil prices the 'chart of truth,'" said Jeff Buchbinder, chief equity strategist at LPL Financial. "If oil stays at $100 a barrel through the summer, the entire formula for valuing stocks will change."
