The S&P 500 is up 76% over the past 3 years and AI stocks like Nvidia have skyrocketed more than 1,300% since the beginning of 2023. That begs the question:
Are we in a stock market bubble?
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BUBBLE or BOOM? Stock Market Valuations in the Age of AI
Look, when you see a handful of massive tech companies driving almost all the gains, and you hear the whispers of “irrational exuberance” again, it’s only natural to get nervous. It reminds me of the 2000 Dot-com bubble and the 2008 financial crisis.
Today, we’re going to look at the three biggest red flags – the valuation indicators that scream “OVERVALUED”.
But, equally important, we’re going to look at the fundamental reasons why this time MIGHT actually be different.
I’ll end it with what a clear strategy for the long-term, buy-and-hold investor like myself, because panic is never a plan.
Why This Looks Like a Bubble
If you look at the historical data, the market today is priced at levels that have almost always preceded periods of very low future returns, or even a major crash. There are three key indicators that paint a picture of extreme valuation.
The CAPE Ratio (Shiller P/E)
The Cyclically Adjusted Price-to-Earnings Ratio, or CAPE ratio, smooths out corporate earnings over the last 10 years, adjusted for inflation, to give a clearer picture of long-term value.
The historical average CAPE ratio for the S&P 500 is typically around 17.6.
We are currently sitting at a CAPE ratio near 39.51.
A CAPE ratio this high has only been reached twice in history: during the lead-up to the 1929 Great Depression and during the 2000 Dot-com bubble.
Historically, when the CAPE ratio is this elevated, the market has delivered significantly negative returns over the subsequent 10 to 20 years.
Simply put, based on history, we are paying an extreme premium for earnings.
The S&P 500 TTM P/E Ratio
The second indicator is the standard Trailing Twelve Months Price-to-Earnings Ratio, which compares the current stock price to the previous year of actual earnings.
TheTTM P/E ratio for the S&P 500 is currently sitting around 27.88.
The long-term average is closer to 16 or 17.
This metric suggests that investors are willing to pay nearly $28 for every $1 of earnings, which is one of the highest multiples on record. This is a sign of intense optimism, perhaps too much optimism, about the near-term future a of corporate profits.
The Buffett Indicator
The third indicator is the Buffet Indicator. It was named this afterWarren Buffett famously called the Market Cap-to-GDP Ratio, as “probably the best single measure of where valuations stand at any given moment.” It compares the total value of all public U.S. stocks to the country’s Gross Domestic Product.
The historical fair value is a ratio of around 100%. That’s often considered fair value.
The current reading is hovering around 217%.
The current value of the stock market is more than double the size of the entire U.S. economy’s annual output. This level is significantly higher than the previous extreme peaks, suggesting a profound disconnect between market optimism and real economic activity.
In summary, the traditional valuation metrics are flashing bright red. If you’re a financial historian, you have every reason to be nervous.
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Why It Might Not Be a Bubble
However, the world isn’t static, and history doesn’t always repeat itself. There are three powerful arguments for why these valuation metrics might be permanently reset – justified by a new era of growth.
The Transformative Power of Artificial Intelligence (AI)
The transformative power of AI is the biggest counter-argument. The current market concentration is driven by a handful of mega-cap tech companies, the AI-enablers.
The growth projections for AI are not just incremental; they are transformational. McKinsey estimates that generative AI could add up to $4.4 trillion annually to the global economy.
If a small group of highly profitable companies can fundamentally rewrite their cost structures and revenue potential using AI, their higher valuations are justified. Their earnings today are a poor measure of their earnings potential in a fully AI-integrated world.
And unlike the 2000 Dot-com bubble, where many high-flying internet companies had zero or negative earnings, today’s market leaders have robust cash flows, strong balance sheets, and proven business models. The high P/E is based on real profit, not just hopes and dreams.
Lower-for-Longer Interest Rates (The Discount Rate)
The second argument is what I like to call the lower-for-longer interest rates, or the discount rate. A stock’s theoretical value is the present value of its future cash flows. When the risk-free rate, which is the rate on U.S. Treasuries, is lower, those future cash flows are discounted less, making them worth more today.
While the Federal Reserve has raised rates not so long ago, they’re starting to lower them again. The long-term, structurally low-interest rate environment that has persisted for decades suggests that central banks may not be able to hold rates high indefinitely.
If the market correctly anticipates a long-term return to a lower-rate environment, the higher P/E ratios are mathematically justified. Low rates make a 28x P/E look less extreme than it did when the risk-free rate was 6% or 7%.
Global Earnings and U.S. Market Dominance
The final point is global earnings and U.S. market dominance.
The traditional indicators like the CAPE ratio and the Buffett Indicator primarily look at the U.S. economy, but the S&P 500 companies are global empires.
Roughly 40% of the S&P 500’s revenue comes from outside the U.S. The Buffett Indicator, for instance, only compares market value to U.S. GDP. It does not capture the vast, growing international revenue of these companies.
The U.S. market has also become the safest, most liquid home for global capital, which drives prices higher, separate from domestic growth. This ‘safe-haven’ premium fundamentally elevates U.S. stock valuations above their historical norms.
A Strategy for the Buy-and-Hold Investor
So, where does that leave you, the long-term, buy-and-hold investor? Should you sell everything and hide under a mattress?
Absolutely not.
The greatest danger in investing is trying to time the market. Missing even a handful of the market’s best days, which often happen right after the worst days, can completely derail your long-term returns.
Here is the simple, three-point strategy for investing in an expensive market:
Point 1: Don’t Try to Time the Top; Invest Continuously: Stick to your core strategy of Dollar-Cost Averaging (DCA). Continue to invest a fixed amount of money on a fixed schedule.
When the market falls, your fixed amount buys more shares. When the market rises, your returns compound. This is the ultimate defense against high valuations.
Point 2: Rebalance and Diversify: If you’ve seen incredible gains from the mega-cap tech stocks, your portfolio is likely over-weighted in that area. It’s not about selling everything, it’s about trimming your winners to bring your portfolio back to its target asset allocation.
Consider diversifying a portion of those profits into lower-valued sectors, international markets, or other asset classes like fixed income to reduce concentration risk. I posted a video recently on what I think are the ideal mix by age.
Point 3: Focus on Quality and Time: In a period of high valuations, quality matters more than ever. Focus your investments on companies with strong balance sheets, high free cash flow, and a clear path to generating sustainable earnings – the very companies most likely to capitalize on the AI revolution.
Most importantly: lengthen your time horizon. The market may deliver weak returns for the next five years, but for the investor with a 10, 15, or 30-year outlook, the long-term power of compounding remains the single greatest force in finance.
The market is expensive. It is risky. But a potential bubble is a long-term risk, not a short-term panic button. Stay calm, stay invested, and let the compounding work for you.
Let me know in the comments: Are you buying, selling, or just holding tight right now?
