Federal Reserve Warns of Stock Market Correction Risk

The Federal Reserve has issued a warning to investors that the S&P 500's equity risk premium is near its lowest level since the dot-com bubble. This means Treasury bonds are more attractive on a relative basis than they have been in decades.

The Fed calculates the S&P 500's equity risk premium by subtracting the real 10-year Treasury yield from the index's forward earnings yield. The current premium is below 2.5%, a level last seen in May 2002, when the S&P 500 declined 16% over the subsequent year.

The Fed's warning comes as inflation hovers at levels last seen in early 2023, and three officials voted for a quarter-point rate hike in July. An increasingly hawkish Fed, coupled with stubborn inflation, has led to predictions that rate hikes are inevitable.