Stock Valuation Metric Sends Warning Signal For US Economy
Record valuations in the U.S. stock market—which may or may not be warranted by earnings and fundamentals—are sparking fears of an impending correction reminiscent of the dot-com crash of the late 1990s.
The Shiller price-to-earnings (P/E) ratio—calculated by dividing share prices by earnings per share—is used as a long-term gauge of stock market valuations, often employed by investors to spot periods when the market is expensive or unusually cheap. Going back over its 150 year-plus history, the P/E ratio has averaged around 17.3, per the Motley Fool, but it recently closed at over 40 amid the ongoing bull run in U.S. equities.
Why It Matters
As noted in an analysis by the Motley Fool, there have only been three times since 1871 when the metric peaked at such high levels—late 1999 and early 2022—both of which preceded major crashes, adding to existing fears over a potential correction on the horizon. These concerns stem from high levels of speculative investment—totaling hundreds of billions of dollars—in artificial intelligence with few manifest payoffs, as well as the market’s top-heavy structure, with significant value concentrated in a handful of AI-bullish tech stocks.
While these conditions do not guarantee any immediate crash, to some they point to a more fragile market that could be disrupted by a shift in confidence or a series of missed earnings, potentially triggering a collapse that could spill into the global financial system.
What To Know
Other metrics similar to the P/E ratio have been flashing red in recent weeks, such as the “Buffett Indicator,” which weighs the value of publicly traded stocks against an economy’s total output. This ratio, named after Warren Buffett and used to gauge potential over- or undervaluation in the market, has been trending above levels the Buffett himself once said meant investors were “playing with fire.”
John Turner, professor of Finance at Queen’s University Belfast and co-author of Boom and Bust: A Global History of Financial Bubbles, told Newsweek that asset bubbles were historically signaled by what he dubs the “bubble triangle”—a metaphor taken from the fire triangle in chemistry and similarly made up of fuel, oxygen and heat.
“The fuel side of the bubble triangle is money and credit—the money and debt that is used to buy the bubble asset, driving up its price. The oxygen side of the bubble triangle is marketability—the ease with which the bubble asset can be bought and sold. The heat side of the bubble triangle is speculation—the act of buying an asset purely in the expectation that its price will increase, without regard for its true worth.”
As Turner notes, “all three sides of the bubble triangle are present,” with speculative investors pouring billions into AI stocks, high levels of borrowing to fund these investments, as well as a clear “spark”—”a radical new technology that will potentially improve productivity.”
William Quinn, co-author of Boom and Bust, told Newsweek that the enthusiasm surrounding AI was “reminiscent of past technological bubbles in railways, bicycles, and internet stocks.”
“We are starting to see narratives emerge about AI invalidating valuation metrics, or about how U.S. markets are exceptional and the usual rules don’t apply,” he said. “There is a certain level of retail speculation in the market, particularly around specific companies with an avid following.”
While recent trade policy announcements have once again spooked investors, the meteoric rise of the S&P 500 over the past three years remains unbroken. Some believe fears of a bubble based solely on valuations may be overblown, and that AI—unlike the unsustainable businesses which epitomized the dot-com boom—could be a fundamentally different kind of market catalyst.
What People Are Saying
Entrepreneur and former presidential candidate Andrew Yang, in a recent interview with Newsweek, said: “You’re in a situation right now where a lot of the value is forward looking and somewhat speculative. It’s really not based upon current revenues, for example. And there are some huge companies that are making massive bets in this space and being rewarded for it in terms of their stock value.”
“In my opinion, it’s hard to assess what the accurate value is and also what the time frame is,” he added. “But it certainly wouldn’t surprise me if there was a significant correction at some point. At the same time, I 100-percent believe that AI is going to transform many industries and that there will be huge winners and losers.”
John Turner, professor of finance at Queen’s University Business School, told Newsweek: “Just as fires need a spark to start them, so bubbles need a spark to begin the exothermic chain reaction. Major historical bubbles have been sparked by one of two things: a radical new technology, or politics. In the case of political bubbles, a set of government policies encourages the flow of money into a particular asset, sparking the bubble.”
What Happens Next
In terms of what could trigger a market correction, David Rosenberg, founder of the economic and market insights firm Rosenberg Research, previously told Newsweek that anything from a “renewed inflation scare” to companies missing earnings forecasts could be sufficient.
“The triggers for a crash likewise do not generally follow any obvious logic,” said Quinn. “The 1929 crash appears to have had no immediate cause at all—as far as we can tell, some large sales triggered margin calls, and everything spiraled from there.”
Read Newsweek’s conversation with Professor William Quinn, co-author of Boom and Bust: A Global History of Financial Bubbles, below:
What does the current valuation of U.S. equities suggest about investor behavior? Is much (too much) of the recent growth speculative/tied to AI and are US equities overvalued?
In the context of US equities, it’s important to remember that historically they’ve been an exceptionally high-yielding long-term investment relative to other asset classes. So what we’re really talking about when we talk about US equity bubbles is brief moments in time when they stopped being quite such a good long-term investment. For that reason, I wouldn’t necessarily expect a reversion to historical price-to-earnings averages.
But even in that context, AI companies account for a large proportion of the market, and at a rough glance they do look somewhat expensive. It’s important to focus on how the sector is going to generate profits. Buying shares in an AI company isn’t a straightforward bet on the potential of the technology, just like buying shares in Pets.com wasn’t a straightforward bet on the potential of the internet.
Do you believe a bubble is forming, and is the current state of the market reminiscent of other periods preceding crashes?
There are some similarities. The nature of AI and the way it is being talked about is reminiscent of past technological bubbles in railways, bicycles, and internet stocks. We are starting to see narratives emerge about AI invalidating valuation metrics, or about how U.S. markets are exceptional and the usual rules don’t apply. There is a certain level of retail speculation in the market, particularly around specific companies with an avid following.
On the other hand, past bubbles have usually happened in an environment of very easy money—most recently with the NFT and meme stock bubbles. Interest rates are much higher now. If rates continue to fall, theoretically that should increase the valuations of technology companies even further.
How long could US equities continue on a bull run, and what could trigger a correction/the bubble bursting?
Unfortunately I don’t think it’s possible to tell when a bubble will burst, at least not without inside information. In historical bubbles, commentators had often been calling a bubble for years before a bear market arrived. By the time of the crash, people were tired of hearing it.
The triggers for a crash likewise do not generally follow any obvious logic. The 1929 crash appears to have had no immediate cause at all—as far as we can tell, some large sales triggered margin calls, and everything spiraled from there.
Warning signs include: an increase in interest rates, a fall in market liquidity, or the government signaling that it is concerned about the valuations of the bubble asset and willing to introduce policy measures in response. But even when these occur, prices can continue to rise for a long time before a correction arrives.