The stock market strategist Ed Yardeni is frequently bullish—and frequently correct. These days, Yardeni is worried that the stock market is headed for a melt-up.
A big rally in stocks might not seem like a cause for concern. But a melt-up is a speculative frenzy that expands valuations but has little to do with earnings. The trigger, he says, may be the President Donald Trump administration’s attacks on the Federal Reserve’s independence—including his recent firing of Federal Reserve Governor Lisa Cook—which could lead to the Fed cutting rates when it isn’t necessary.
The problem with melt-ups is that meltdowns usually follow. One case in point: The “tech wreck” of the early 2000s that succeeded the tech bubble created in part by Fed rate cuts.
We chatted with the president of Yardeni Research recently about why Fed credibility is critical to American exceptionalism, and why he’s still bullish on America. Keep reading for an edited version of our conversation.
Keeping the Fed’s Credibility
Leslie Norton: You’re a former Fed economist. The Fed faces a big challenge to its independence today.
Ed Yardeni: Can the Fed maintain its credibility? How will financial markets, the bond vigilantes [investors who try to discipline the government by selling], respond to a Fed politicized by the White House?
Presumably, the president will have [Fed governors] Christopher Waller and Michelle Bowman, and [governor nominee] Stephen Miran in January, assuming he gets through the Senate, willing to accommodate his request. Firing Lisa Cook is unprecedented. [The Fed has said it would abide by any court decision on whether Trump has the legal authority for this action]
If the FOMC [the Federal Open Market Committee, which sets monetary policy] confirms that it’s not acting independently anymore—say if the inflation numbers run hot and August payroll is better than expected, and the Fed cuts the fed-funds rate in the next few meetings, even if the economy demonstrates it doesn’t really need those cuts—the Fed’s credibility will become increasingly questionable.
The bond market could respond negatively. The stock market, however, could experience a melt-up.
There’s a certain sense of déjà vu with the 1998-99 tech bubble. At the end of 1998, the Fed cut the fed-funds rate by 75 basis points, but we had an outright financial crisis created by the collapse of Long-Term Capital Management. The rate cuts fueled the tech bubble. That took the Nasdaq up dramatically in 1999, and set us up for a tech wreck in the early 2000s.
Norton: So, what happens?
Yardeni: Fed officials say they’re laser-focused on their dual mandate. By law, they’re required to do their best to keep the unemployment rate down and to keep inflation down. What should be their third mandate, but isn’t required by law, is financial stability. [Fed Chair Jerome] Powell and other officials say it’s hard to achieve the two mandates without financial stability. So, this could be a game changer in terms of the way people look at the Fed, its credibility, and its influence on the markets.
Norton: You’ve written a lot about American exceptionalism. How much has that relied on Fed independence?
Yardeni: Fed independence is a critically important component of American exceptionalism. Other countries’ central banks are nominally deemed independent, but the Bank of Japan can be influenced by fiscal authorities. The Bank of England and the European Central Bank are relatively independent. The US is really exceptional in the size, scale, and safety of our capital markets. Those capital markets do require an independent Fed.
Why the Stock Market Could See a Melt-Up
Norton: Your S&P 500 targets are 6,600 by year-end, and 7,700 by the end of 2026. But you think there’s a 25% probability of a melt-up that gets us to 7,000 this year. First, what’s a melt-up?
Yardeni: It’s a speculative rally led by valuations. You only know for sure that you’re experiencing a melt-up once it leads to a meltdown. It is not a good thing. Stocks are a long-term investment. A lot of Wall Street types try to pick tops and call corrections. The problem is that while they might be good at calling tops, they often forget to call bottoms. I have a relative I don’t talk to often who calls me up at bottoms and says, “Eddie, should I get out?” That’s how I know for sure that that’s a market bottom, especially if the bull/bear ratios are depressed.
The name of the game is to invest for the long run. You want to feel comfortable putting money in the market without the kind of volatility we had in 1999-2000, or 2008-09, or even around the tariffs, from Feb. 9 to April 8. Then the next day, we were up 10% and never looked back. Now we’re at record-high territory.
Norton: Earnings have held up well.
Yardeni: Earnings beat expectations for both the first and the second quarters. If we have an earnings-led bull market, which I expect, we should be OK. I’m forecasting S&P 500 earnings will increase from about $265 a share this year to $300 a share next year, and then $350 a share in 2027. The market is looking ahead to next year’s likely earnings. If it agrees with me and uses the 22 multiple we have now, we get to 6,600 on the S&P 500 by the end of this year. By the end of 2026, I think the market looks at $350 a share in 2027 and multiplies that again by 22. That’s a very high multiple by historical standards. We got up to 25 in 1999.
Why Earnings Are Key to the Roaring 2020s
Norton: Don’t forget those pesky tariffs.
Yardeni: Since 2020, I’ve promoted the idea of the roaring 2020s. Technological innovations could boost productivity and real economic growth, keep a lid on inflation, and be quite positive for real incomes, as well as for corporate profits. Productivity is the fairy dust of the economy. If that’s the case, then the earnings story should be all right.
If the Fed cuts rates and it’s not really necessary, the melt-up would take us from today’s elevated multiple to 25, which is where we were in late 1999, early 2000. There was a lot of air back then: The earnings were nowhere near as strong as today.
The market has had a lot of agita this past year. It’s very hard to factor in the tariffs because the White House changes the rules of the game almost daily. The market has demonstrated that it can handle a tariff of 10%-15% across the board. That’s remarkable. It confirms what I’ve been saying for three years: Don’t underestimate the resilience of the economy. It withstood a pandemic, then an inflation shock, then a dramatic tightening in monetary policy. Now we have tariffs. The economy has been through thick and thin since the two-month recession during the lockdowns of March and April 2020. It’s now demonstrating its resilience, as is the stock market, in the face of what basically is a tax increase. The only question is who’s paying that tax? American consumers, American business, or foreign exporters? So far, it’s American business, but increasingly, it’ll probably be American consumers. And yet, the economy is doing relatively well.
Why Baby Boomers Are Boosting the US Economy
Norton: Are consumers up to the task?
Yardeni: I’m a baby boomer. I still work for a living, but a lot of my friends are retired or retiring. Boomers are the wealthiest retiring generation we’ve ever had in America. They collectively have $80 trillion in net worth, which is half the net worth of the entire household sector. I think, as they retire, the savings rate will go down or even go negative, because they will be spending their retirement assets, and of course, they won’t have any more income. Anecdotally, I can tell from my own life and those of my friends that boomers are helping their kids with down payments for mortgages, paying for summer camps for grandchildren. There’s a lot of strength in the consumer sector related to that pile of net worth. They’re spending it on healthcare, leisure, hospitality, financial services—and all those areas have record employment. They’re keeping the consumers going. Obviously, the younger consumer, the lower-wage consumer, is struggling.
Norton: Not everyone has well-off, retired parents who can help.
Yardeni: But I think it explains why the consumer has been so remarkably resilient. Layoffs remain extremely low, but people who are unemployed are finding it harder to find a job. That means the duration of unemployment is increasing, and that caused the unemployment rate to go up by about a percentage point over the past year. It’s still low at 4.2%, which, most people agree, is still full employment.
I do think we’ll see a slower pace of employment. We don’t have to have the jobs go up 150,000-200,000 per month to keep the unemployment rate down. Maybe it’s more like 100,000-150,000, because labor supply has been affected by structural developments. Boomers are retiring, the administration has shut down immigration, and we have deportations, so the supply of labor is down. The number of workers that we need to hire to maintain balance in the labor market has diminished.
Is a Small-Cap Rally in Store?
Norton: The stock market is broadening. Will we see a small-cap bull market at last?
Yardeni: It has been a broad bull market. But gains in most stocks are puny compared with the Magnificent Seven. Since the bull market began in October 2022, many stocks are up 20%-50%. They’re just not up 70%-100%. The Magnificent Seven has outperformed and now accounts for 30% of the market cap of the S&P 500.
Since the beginning of the bull market, I’ve recommended overweighting information technology, communication services, industrials, and financials. I recommended energy for a while and gave up. But at this point, rotate into the small caps and mid-caps in those sectors, because they are relatively cheaper and are likely to do better if the Fed does, in fact, lower rates.
Norton: Can they outperform the S&P 500 on a sustainable basis?
Yardeni: The S&P 100, dominated by the Magnificent Seven, has been outperforming the S&P 500. In a melt-up situation, it could certainly continue to do that. I hope to see the market broaden out. To see investors moving out of highly valued stocks toward more reasonably valued stocks would certainly keep the bull market going and would reduce the risk of a valuation melt-up.
In a melt-up scenario, the Magnificent Seven, the S&P 100, would outperform. Right now, IT and communication services account for 44% of the market cap of the S&P 500. In the past, my rule of thumb was to lighten up when it got to a third of the market cap of the S&P 500. But that hasn’t been the case this time around, because the economy is becoming more high-tech in nature.
Smid caps have really had no earnings growth since 2022, so I’m waiting to see earnings improve. It’s hard to find any real bargains in growth, but I do think smid-cap financials and smid-cap industrials make sense here.
Norton: International became a strong theme this year.
Yardeni: I look at a US stock market index and divide it by a non-US stock index. That ratio has risen since 2010 as the US outperformed. Nothing goes straight up forever, so the ratio declined this year.
I would continue to overweight the US. It’s 75% of the market cap of the world’s collective stock markets. I have no problems with diversifying overseas, as long as you focus on picking stocks rather than countries to overweight. It’s hard to get the countries right. I continue to believe staying home is a better way to invest than going global. Our earnings in America have been very strong.
Norton: Thanks, Ed.