S&P 500 faces 4 risks as stretched valuations meet hawkish Fed

Four converging threats — from stretched valuations to a potential slowdown in AI infrastructure spending — are testing the durability of the S&P 500's three-year rally.

The S&P 500's 9.6% year-to-date gain masks four converging risks that investors say could trigger a 5% to 10% pullback. The benchmark index has delivered double-digit returns in each of the past three years, leaving many questioning how much further it can run.

"Once you spend 1% to 2% of GDP on something like AI, if it ever declines, that's just going to ripple through the economy," said Michael Antonelli, managing director at Baird.

The excess CAPE yield — the gap between the S&P 500's earnings yield and the 10-year Treasury yield adjusted for inflation — sits at about 1.3%, near its lowest level in a decade. Nine of 19 Federal Reserve policymakers project at least one more rate hike this year, and traders now price an 89% probability of a December increase, up from 61% before the Fed's June meeting. Net equity issuance by nonfinancial companies turned positive in the first quarter for the first time since 2021, with SpaceX raising $86 billion in its initial public offering and Alphabet announcing an $85 billion equity offering.

Any one of these factors could drive a 5% to 10% correction, but a combination — a hawkish Fed, slowing AI investment and rising equity supply — would test whether the bull market has room to run after three consecutive years of double-digit returns.

Valuations Stretch as Bond Yields Compete

The S&P 500's forward price-to-earnings ratio has actually declined this year as profit expectations have risen faster than prices. But the equity risk premium — the compensation investors demand for owning stocks over risk-free bonds — has narrowed to levels that historically preceded weaker returns. The 10-year Treasury yield climbed this spring, driven in part by a war-fueled surge in energy prices that pushed inflation expectations higher. While oil has since retreated below $80 a barrel after progress in US-Iran negotiations, bond yields have only partially retraced, leaving the equity-bond competition unusually tight.

New Fed Chairman Kevin Warsh reinforced the hawkish tilt at his first press conference last week, emphasizing the committee's "unanimous and unambiguous" commitment to price stability. The dollar index held near a 13-month peak, reflecting expectations that US rates will stay higher for longer. Gold edged up 0.4% to $4,176.52 an ounce as investors weighed the Fed's stance against easing energy-driven inflation concerns. The CME FedWatch Tool now shows an 89% probability of a rate hike in December, up sharply from 61% before the central bank's June meeting.

AI Capex at Risk as Costs Bite

The biggest single threat to the rally, many investors say, is a pullback in artificial-intelligence infrastructure investment. Spending on data centers and other AI infrastructure this year by just four big tech companies is expected to total more than $670 billion — a larger investment as a share of the economy than the railroad expansion of the 1850s.

Yet questions are mounting about the returns on that spending. OpenAI is considering drastic price cuts as businesses balk at the cost of AI usage, according to a Wall Street Journal report, while competitor Anthropic was expected to turn a quarterly profit ahead of expectations. The divergence highlights the uncertainty around whether AI model providers can monetize their technology at scale. A pullback in AI infrastructure investment would ripple through the economy, affecting not just tech stocks but also industrial and materials companies tied to data center construction.

Surging equity issuance adds another layer of risk. Net equity supply turned positive not long before previous selloffs in 2000 and 2022, and the current wave — driven by companies funding AI investments at elevated share prices — could eventually test investor demand. SpaceX's $86 billion IPO and Alphabet's $85 billion offering represent the two largest equity raises in recent memory. "Positive net equity issuance was likely not a major factor in previous stock bubbles bursting, but I think you can argue that it was possibly a contributing factor," said Joe Maher, markets economist at Capital Economics.

The next event for markets comes later this week with the release of the Personal Consumption Expenditures price index, the Fed's preferred inflation gauge. A hot reading would reinforce the case for higher rates and further compress the equity risk premium, while a cool print could ease some of the pressure that has built since Warsh's hawkish debut.

This article is for informational purposes only and does not constitute investment advice.