Two red flags appear at the same time, and the US stock market may plunge by 50%

Despite multi-decade highs in interest rates and recession predictions, U.S. stocks bucked the trend this year and showed a surprisingly strong performance. This rally was helped by slowing inflation and the hype of artificial intelligence. But recently, the Fed's steadfast stance on maintaining higher interest rates and deep turmoil in the bond market have served as a wake-up call for stock market sentiment, causing the S&P 500 to cut its year-to-date gains.

In fact, according to media research, U.S. stock valuations are getting higher and higher, increasing the risk of correction. One particularly noteworthy indicator that is "flashing red" is the valuation of stocks relative to the bond market.

In August, the S&P 500 climbed to the height of the dot-com bubble, according to global analytics platform Koyfin. Despite the recent correction in the stock market, the indicator remains near these highs.

After the indicator last surged to such highs in the spring of 2000, U.S. stocks experienced a prolonged crash, with the S&P 500 plunging 50% between March 2000 and October 2002.

Another indicator of excessive U.S. stocks relative to bonds is the so-called equity risk premium, which is the additional return of stocks relative to government bonds. This year, the metric has fallen sharply, reaching multi-decade lows, indicating that stocks are on the high side.

Research firm MacroEdge said in a recent blog post that the equity risk premium is near its lowest level since 1927. This has happened six times, with similar situations triggering major market corrections and recessions or depressions in 1929, 1969, 1999/2000, 2007, and 2018/2019.

In recent months, several experts, including Luca Paolini, chief strategist at Pictet Asset Management, have expressed similar sentiments.

"The so-called equity risk premium (earnings yield minus bond yield) recently fell to new cyclical lows and is well below historical averages. In other words, despite the recent correction, the stock market has become more expensive relative to the bond market. Financial news analyst Streetinsider.com recently quoted Roth MKM analyst Michael Darda as saying.

DoubleLine Capital's chief executive, the "new debt king," Gunlack, also said last month that stock prices were too high and the U.S. economy could fall into recession within the next three quarters. "I think the (U.S. stock) market is quite overvalued," and "it's hard to get interested in stocks when the risk premium hits its lowest level since 2017." ”