Wall Street’s relentless climb offers both a spectacular show and a precarious wager on the world’s most dynamic economy. US stocks are scaling valuation peaks not seen since 1929 or 1999, driven by AI enthusiasm and expanding multiples. While sceptics see a bubble ready to burst, optimists argue that growth is justified.
From the Nifty Fifty craze of the 1970s to the dotcom frenzy of the late 1990s, history shows markets often overheat. Today, some commentators say the biggest risk lies across the Atlantic.
“America is overvalued and overhyped to a degree never seen before,” wrote Ruchir Sharma, founder of Breakout Capital, in his recent Financial Times column. Sharma warned we are heading for the “mother of all bubbles,” which is “sucking money away from the rest of the world.” His perspective is informed by his role investing in emerging markets.
High valuations, high stakes
US stocks are undeniably expensive. Much of the recent surge stems from investors willing to pay ever-higher multiples for each dollar of profit.
Jurrien Timmer, strategist at Fidelity Investments, notes that over the past year, dividends contributed just 1 percent to market returns, while earnings growth added 8 percent. The largest driver, however, was multiple expansion, accounting for 22 percent. In contrast, emerging markets delivered the same 8 percent earnings growth, but with 3 percent from dividends and just 1 percent from multiple expansion.
The Cape ratio warning
Is this willingness to pay more for equities rational? Yale professor Robert Shiller’s Cyclically-Adjusted Price-to-Earnings Ratio (Cape ratio) offers a historical perspective. The Cape ratio smooths earnings over a 10-year period, adjusted for inflation, to filter out short-term economic noise.
At the start of December, the Cape ratio for US stocks stood at 38.8 — a level only reached during the dotcom bubble and briefly in early 2022 before a market correction.
Yet some investors remain unfazed. Joe Little, global chief strategist at HSBC Asset Management, attributes the momentum to expectations of tax cuts and deregulation in key sectors like industry and finance.
Sentiment keeps the rally alive
Roelof Salomons, professor of investment theory at the University of Groningen and chief strategist at BlackRock Netherlands, suggests ignoring valuations — at least for now. “As long as positive sentiment around the AI boom persists, upside growth continues to surprise, and inflation keeps falling, allowing the Fed to cut rates, Wall Street will remain a favourite.”
Even some within Sharma’s own camp acknowledge the overvaluation but don’t foresee an immediate correction. Robert Armstrong and Aidan Reiter of the FT’s Unhedged column note: “Earnings growth for the S&P 493 is projected at 11 percent over the next one to two years, compared to 9 percent for the Europe 350. That difference may seem small, but over time it significantly impacts valuations.”
The US still needs to deliver on these expectations. Higher long-term interest rates, a strong dollar, and declining global trade weigh on corporate profits. While the Federal Reserve has so far engineered a “soft landing,” policy missteps remain a risk, Little warns.
Bubble or justified optimism?
Are we in a bubble? Maybe. Or perhaps this is the price of investing in a dynamic economy. As Peter Lynch wrote in One Up on Wall Street, “No one can predict the markets with any useful consistency, any more than the ‘gizzard squeezers’ could predict when the Huns would attack Rome.”
And as Warren Buffett reminded us in his 2015 letter to Berkshire Hathaway shareholders: “For 240 years, it has been a terrible mistake to bet against America. And this is not the time to start doing that.”
Yet, nearly a decade later, Buffett’s actions raise eyebrows. Berkshire Hathaway now holds more cash (320 billion dollars) than equities (272 billion dollars) in its portfolio. Perhaps the Oracle of Omaha is hedging his bets.
With the S&P 500 moving sideways this month, the market’s next move remains anyone’s guess.
Further reading on Investment Officer Luxembourg:
- European smallcaps ‘deeply undervalued’, says Edmond de Rothschild AM
- 10 possible surprises for investors in 2025
- Wait, bonds are back? Still?