Another 'Irrational Exuberance'? Fed Governor Lisa Cook Warns Stock Valuations Could Signal Major Market Risks

Former Federal Reserve Chairman Alan Greenspan warned of irrational exuberance in 1996, and now Federal Reserve Governor Lisa Cook is cautioning that U.S. stock valuations are too high. It is quite rare for Fed officials to directly warn of market risks.

On Monday, Federal Reserve Governor Lisa Cook issued a rare direct warning about the stock market. She stated: "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, suggesting that markets may be priced to perfection and, therefore, susceptible to large declines, which could result from bad economic news or a change in investor sentiment."

This statement echoes the "irrational exuberance" warning from former Fed Chairman Alan Greenspan in 1996. However, unlike Greenspan's remarks, which immediately impacted the stock market, Cook's warning appears to have been largely ignored. The S&P 500 index regained its footing above 6,000 points that day, near its all-time high, although gains were somewhat tempered, closing with a 0.6% increase.

Undeniably, by historical standards, market valuations are indeed at high levels according to several metrics: According to Goldman Sachs, the S&P 500 index's ratio relative to its book value and sales is two standard deviations above the average of the past decade. Economist Robert Shiller's cyclically adjusted price-to-earnings (CAPE) ratio is also around 37, close to the highest level since the dot-com bubble burst.

In addition, the S&P 500 index achieved at least a 20% gain for the second consecutive year last year.

However, high valuations do not necessarily mean that the market is on the brink of collapse. Just as Greenspan's warning came four years before the peak of the dot-com bubble, a state of high valuations can persist for a considerable time.

Art Hogan, Chief Market Strategist at B. Riley Wealth, said Greenspan "wasn't wrong but he was four years early in making that call. It seems from that point forward, officials have tried to stay away from valuation commentary."

Meanwhile, five of the 11 sectors in the S&P 500 outperformed the broader index by the end of 2024, indicating that the rally has begun to broaden beyond the tech giants, which could help alleviate valuation concerns if true.

Almost every Wall Street strategist expects the market to rise. Even among the minority of analysts who predict a market decline, such as Stifel's Barry Bannister, other factors (such as economic deterioration) are needed in addition to valuations to trigger a market correction.

At the same time, if fundamentals begin to deteriorate, high valuations could make the market vulnerable.

Kevin Simpson, CEO of Capital Wealth Planning, said in a report on Monday: "Fourth-quarter earnings season will start next week, and we expect [earnings] to be front and center as investors look for earnings growth to support present valuations and to analyze how companies are reacting to a declining federal-funds rate. Consensus for 2025 EPS growth is close to 15% — which is more than double the historical average. If earnings season offers any red flags on expectations, especially from mega-cap tech names, it'll amplify the concern on valuations."