Could Stocks Fall 20%? The Figure Sending a Bright Warning Signal to the Market
The author is a cofounder and owner of Meitav Investment House.
Events keep chasing one another in our world. By the time this was written, the Iran-Israel war had resumed and then stopped again. Markets are reacting, not only equity markets but also bond markets. Last Friday, June 5, something significant happened on Wall Street: prices of U.S. government bonds fell sharply after the release of the employment report, which pointed to the strength of the American labor market. The report raised concerns about another step up in inflation, and bonds responded accordingly. The decline in bond prices led to a particularly sharp drop in stock prices on Wall Street, although other reasons were also behind it. ● Japan pushes interest rates to a 30-year high, and puts Wall Street on edge ● Japan and Europe at the expense of the U.S.: global debt is at a peak, and these are the implications
The earnings season for U.S. companies for the first quarter of 2026 is ending these days. These reports, in general, and especially those of the giant technology companies, were excellent and indicated a significant improvement in profitability. On the face of it, they justify the continued rally in stock prices, despite what stocks have already done. But against this stands one major obstacle, the drop in U.S. government bond prices, which has pushed them to future yields to maturity not seen in many years, 4.58% on the 10-year bond and 5.05% on the 30-year bond. This is, of course, a bright warning sign for the stock market.
It is therefore not surprising that warnings from market "lions" in the United States are not slow to come. For example, Ed Yardeni, a veteran and respected investment strategist, pointed out that the United States is not alone, since what is happening in U.S. government bonds is also happening in Europe and Japan, in a way that could create competition over where the money will flow. He also warns against a loose policy by the Federal Reserve, led by incoming chairman Kevin Warsh, which could make it too late in dealing with inflation.
Jeffrey Gundlach, the American investor and fund manager, sees a real danger of interest rate hikes and therefore recommends a 20% cash holding, alongside investments in commodities and gold. Michael Burry, known for predicting the subprime crisis and for making a fortune in 2008 from his short strategy, has been warning for about a year and a half about the very high price level of technology stocks, especially around the AI euphoria, and sees parallels to the internet euphoria of the dot-com bubble. The respected Ray Dalio, founder of the hedge fund Bridgewater, shares the view that stock prices are high, but not to the point of a bubble. Michael Hartnett, chief strategist at Bank of America, says the stock market is in an extreme state of overbought conditions. Investors have become $4 trillion richer since the beginning of the year, but their cash balances for future purchases are approaching zero. The market has shot up in what is known as a melt up, driven by emotions and fear of missing out, rather than sound economic reasons. A Bank of America index measuring the ratio of bullish to bearish stocks is at its peak, reflecting a complete consensus that markets will continue to rise. In short, all the signs point to a deep correction soon, and he suggests investors flee the market while they still can, in the spirit of the long-known saying, "Sell in May and go away."
And Buffett? After retiring from managing Berkshire Hathaway, he left his successor a portfolio swollen with cash, after finding himself "struggling to find stocks worthy of investment at today's prices." Of course, there are also optimistic forecasters who believe the rally will continue, for example hedge fund investor Cathie Wood.
The market metrics at record levels
Stock prices in the United States are usually measured against three main indicators. There is Buffett's indicator, which analyzes the ratio between the market value of U.S. stocks and GDP. When this ratio approaches 200% and even rises above it, it is dangerous. Today the ratio stands at about 250%.
The second indicator is Robert Shiller's, the Nobel Prize-winning economist. It measures the average profit of U.S. companies over the past 10 years, adjusted for inflation, and from there derives the multiple, rather than relying only on earnings from the latest year. There is a lot of logic in this model, but there is also a drawback, because it does not quite capture fast-growing high-tech companies. The average multiple according to this indicator in U.S. market history is 17, while today it stands at 42, almost an all-time high. The only other two times this indicator was at such levels were on the eve of the dot-com crash in 2000, and more recently on the eve of the sharp declines in the U.S. stock market in 2022. Zvi Stepak / Photo: Itzik Biran
The third indicator, which may be the most relevant, is called the Fed model. It compares stock market valuations with those of the bond market. If the forward multiple, 12 months ahead, of the S&P 500 stands at 21, then the multiple of U.S. government bonds stands at 20, based on a current yield to maturity of about 5.0%. Since government bonds are considered a risk-free asset, despite the enormous size of U.S. debt, we would expect the stock multiple to be lower than that, but that is not the case.
Explosions in the Gulf make waves on Wall Street
Why have we reached this situation? On the stock side, the rally is based, as noted, on a significant improvement in the profitability of publicly traded companies, and on the euphoria of private investors driven by natural greed in such situations, as well as by a sense of possible regret if they do not hurry to invest, which puts a lot of pressure on them. On the government bond side, the main reason for the sharp declines recorded since the start of the latest confrontation with Iran stems directly from that campaign. Among other things, it caused an increase in oil prices and all their derivatives, and there are many. Supply chains have been disrupted, including fertilizers, which is driving up agricultural commodity and food prices. This also includes, of course, chips, which are suffering from supply shortages and whose prices are soaring, lifting the prices of the companies that manufacture them or test their quality. The clear result is a rise in the inflation rate. If until about three months ago markets were signaling that interest rates around the world were set to fall, today they are already signaling the possibility of rate hikes, in the United States, in Europe and in other countries. In some cases this is not just a possibility, but actual hikes, such as in Norway and Australia. The key question is how long the supply chain disruptions will last, since if they continue they will lead to greater damage.
The new investors are shaking up the market
So, are we witnessing the development of a bubble or not? My answer is no. There is no bubble. True, there are signs in the markets that characterize a bubble, especially the behavior of private investors driven by fear of missing out on gains, there is a widespread consensus that the gains will continue, and there are many IPOs and investors rushing into them. Still, this is not a bubble at this stage. Stock prices are indeed high, but they have not detached from reality. A correction of 15% to 20% to the downside in stocks is certainly warranted, but not a real crash. At the same time, it should be taken into account that just as in a stock rally, a bull market knows how to exaggerate, so too, symmetrically, a market with bearish characteristics knows how to exaggerate in the other direction. This is especially true now that masses of investors have joined it, investors who have not yet tasted the flavor of a mini crash, and they may themselves turn it into a crash.
Nothing in the above should be regarded as a recommendation or a substitute for the reader's independent judgment, or as an invitation to make any purchase, investment and/or other action or transaction. Errors may appear in the information and market changes may occur.