The U.S. stock market has been soaring lately, with the S&P 500 index rising by about 57% in the past two years. This has more than doubled the index’s value over the last five years. But such rapid growth has many investors wondering if it’s sustainable.
Some worry that the market is in a bubble, fueled by hype around AI and other tech advancements. They fear a potential crash down the road. To understand this, it helps to know what a stock represents.
Essentially, it’s a stake in a company’s future earnings. Think of owning a rental house. The rent minus expenses is your profit.
The house’s market value can change, but its true worth depends on the rental income. Stocks work the same way. They generate earnings, and their prices are often compared to these earnings using the price-to-earnings (P/E) ratio.
For example, say a rental house makes $24,000 per year and sells for $240,000. Its P/E ratio is 10. If the same house sells for $480,000, the P/E becomes 20.
That’s a higher valuation but a worse deal for new investors. The same goes for the stock market.
Stock valuations and potential risks
A $100,000 investment in 2019 could now be worth around $256,960 – a 157% gain. But earnings from those investments have only grown 42% in that time. So the average P/E ratio has jumped from about 20 to around 30.
Notably, much of the recent rally has been driven by seven big tech companies: Apple, Nvidia, Microsoft, Amazon, Google, Facebook, and Tesla. These “Magnificent Seven” make up over 25% of the S&P 500’s value. And they have much higher P/E ratios, especially Tesla, which often trades on potential future earnings rather than current profits.
Excluding these tech titans, the P/E of the rest of the S&P 500 looks more reasonable. The rapid progress in AI tech is a big reason for the current optimism in tech stocks. The hope is that AI will dramatically boost productivity across many industries, driving future earnings growth.
But there’s still a lot of uncertainty. It’s hard to know just how much AI will impact the economy. It could cause unforeseen issues too, like cost overruns, competition, or even unemployment from automation.
Looking back, the U.S. economy has steadily grown around 3% after inflation, despite many tech and social changes over time. So while the market’s future is unclear, knowing its history and how it works can help investors keep expectations in check and make smart choices. The boom may reflect real growth potential from tech innovation.
But it also comes with risks that investors need to keep in mind. Only time will tell if the market is in a bubble or just hitting new heights.
