The Stock Market Will Drop Sharply If History Repeats. Warren Buffett Explains Why.

The U.S. stock market is charging higher at an astonishing pace. Since March, the S&P 500 (SNPINDEX: ^GSPC) had advanced 16%, while closing higher in nine straight weeks. And the Nasdaq Composite (NASDAQINDEX: ^IXIC) has advanced 25%, its largest two-month return since 2002.

Yet the stock market is vulnerable. Treasury yields spiked in May as high inflation strengthened the case for interest rate increases. History says elevated Treasury yields could sink the stock market.

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Oil prices retreated last month over reports that the U.S. and Iran have reached a preliminary agreement for an extended ceasefire. Yet, Brent crude futures (an international benchmark) still trade above $90 per barrel, up more than 50% since the year started, and consumers are paying the price.

The Consumer Price Index (CPI) increased 3.8% year-on-year in April, the hottest inflation reading since May 2023. More concerning, core CPI inflation (which excludes volatile food and energy prices) also accelerated, a sign that elevated energy prices are spreading to other areas of the economy by raising manufacturing and transportation costs.

Unfortunately, inflationary pressure is unlikely to relent for several months even if the U.S. and Iran resolve their differences tomorrow. Oil infrastructure in the Persian Gulf has been damaged and will take time to repair. In addition, restarting oil wells is more complex than turning on a faucet; it could take weeks or even months for oil flows to reach pre-war levels.

In the meantime, the Federal Reserve may fight inflation by raising interest rates. Investors expect rates to increase at least 25 basis points in the next year, per CME Group 's FedWatch tool. Higher rates tend to hurt the stock market, partly because corporate earnings grow more slowly as higher borrowing costs suppress spending, and partly because higher rates compress stock market valuations.

Warren Buffett once explained the correlation between interest rates and stock prices. "The most important item over time in valuation is obviously interest rates," he told CNBC in 2017. "If interest rates are destined to be at low levels, it makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield," he added.