The stock market has seen a remarkable surge in recent years, with the S&P 500 index rising by 57% in just two years and more than doubling over the past five years. This growth has allowed many people to reach their retirement goals sooner than expected. However, there are concerns about whether this growth is sustainable or if it is a bubble that could burst.
To understand the current market situation, it’s important to look at the fundamentals of stocks. A stock represents ownership in a company, and profits come from dividends and capital gains. The recent stock market gains have outpaced the growth in underlying company earnings, leading to higher price-to-earnings (P/E) ratios.
This means that future profits as a percentage of portfolio value are expected to be lower. The recent stock market euphoria can largely be attributed to seven major tech companies, often referred to as the “Magnificent Seven.” These companies have driven about three-quarters of the recent market growth due to the hype around Artificial Intelligence. While the rise of AI has revolutionized industries and made tasks more efficient, there are uncertainties about the future.
Cost overruns, competition, potential AI ethical issues, and broader economic impacts could affect these companies’ stock prices. History suggests that economic growth averages out to a steady figure of about 3% after inflation over time.
Stock market bubble concerns intensify
While the current tech-driven gains are exciting, investors should be cautious of overvaluations and potential market corrections in the future. The NASDAQ Composite Index has quadrupled over the past decade, leading to inflated valuations. Key indicators are flashing red across financial markets, suggesting that assets may be entering speculative territory.
Market sentiment is high, with nearly 53% of Americans expecting stock prices to rise in 2025. Valuations are stretched, with the S&P 500 cyclically adjusted price-to-earnings ratio (CAPE) at 38, compared to the historical average of 18. Irrational exuberance is also evident, with equities making up 43% of Americans’ household financial assets, the highest level ever recorded.
Market bubbles have often emerged alongside new technologies throughout history, much like AI today. Unexpected risks such as geopolitical shocks and resurging inflation could significantly jolt financial markets. To reduce risk exposure, advisors can consider multi-asset strategies with a diversified portfolio instead of betting big on a brewing asset bubble.
The US equity market has been a dominant force in global investing for decades, but there are concerns about its concentration and valuation. With nearly 30% of local retirement funds now allocated to US equities, the implications of a market correction could be significant. Fund selectors should be looking beyond the US for value to mitigate the risks of over-reliance on the Magnificent Seven tech giants.
