The US stock market has been having a stellar run – so much so that many investors fear it is overpriced.
Since early 2023, the benchmark S&P 500 has risen more than 60 percent, hitting all-time highs despite headwinds ranging from US President Donald Trump’s tariffs to concerns that artificial intelligence (AI) may be overhyped.
For investors, the explosive growth has come at a cost: by some measures, US stocks are pricier than ever before.
An investor buying into the S&P 500 last week had to fork over $3.25 for every $1 in revenues generated by its 500 constituent firms, according to GuruFocus, the highest price-to-sales ratio on record.
While US stocks look less expensive when compared against forecasts of company profits, the benchmark index is still trading at more than 22 times forward earnings, well above the historical average.
In a poll by Bank of America last month, nine out of 10 fund managers surveyed said they viewed US stocks as overvalued.
The market’s sky-high valuation has led some analysts to draw comparisons to the dotcom bubble of the late 1990s.
Fueled by excitement over the rise of the Internet, shares on the tech-heavy Nasdaq soared about 80 percent before giving up almost all of their gains between 2000 and 2022.
“Nobody knows what a stock is really worth because its value is based on future earnings,” said James Angel, an expert on financial markets at Georgetown University’s McDonough School of Business.
“Only God knows what the future holds. Because of this uncertainty, stock prices always have been and always will be very volatile. A small change in the market’s consensus estimate of future performance can lead to a large and sudden change in value.”
Even as investors are increasingly expressing qualms about the price of US stocks, they are not staying away.
The S&P 500 set five all-time highs in August alone and is up about 10 percent so far this year, putting it on track to comfortably beat its average annual return in 2025.
Analysts have offered a range of explanations for the market’s untrammelled ascent, including the remarkable profitability of the “Magnificent Seven” – Apple, Microsoft, Tesla, Meta, Amazon, Nvidia, Meta and Alphabet – and the as yet untapped potential of AI.
“Earnings at US companies have held up surprisingly well, and continue to grow,” said Aswath Damodaran, a professor of finance at the Stern School of Business at New York University.
“AI may have driven up the value of a couple of the big tech companies and companies that build AI architecture, but it cannot explain the overall rise in the rest of the market,” Damodaran added.
While the market’s heavy reliance on the “Magnificent Seven” has been a source of concern for some investors – they make up about one-third of the S&P 500 – such concentration is not unprecedented.
Robert E Wright, lecturer in the Department of Economics at Central Michigan University, said the dynamic of a few companies dominating the market can be found as far back as the late 18th century.
“Banks were the most important technology of the time, followed by property insurers,” Wright said.
“Later came textile mills and other manufacturers, then railroads and, eventually, automobiles. We cannot get too precise due to differences in the way capitalisation was measured, but the pattern seems the same: innovations leads to success, which leads to investment and more success until commodification. Then innovation in a different field occurs and the cycle begins anew.”
Herd behaviour
More prosaic explanations have been offered for the market’s stellar performance, too, such as the shift away from actively managed mutual funds toward passive index funds in recent decades.
The increasing popularity of funds that track the S&P500 and other broad measures of the market means that more people are buying stocks regardless of economic conditions than in the past.
But a bigger factor than any economic metric could be human psychology.
Stephen Thomas, a professor at Bayes Business School in the UK, said that herd behaviour provides a better explanation for stock market moves than the performance of businesses or the state of the economy.
“The only tried and tested investment strategy with both international, cross asset and historical support is ‘momentum,’ ie, what goes up carries on rising until it doesn’t,” Thomas said.
“Fund managers can’t afford to get left behind their competitors,” Thomas added.
“And these are using momentum either explicitly or quietly. So they are behaving rationally in terms of firm behaviour, and indeed, in terms of our knowledge of investment strategies.”
Steep falls
There is no way to accurately predict a stock market crash.
But steep falls are a regular feature of the market.
Since the end of World War II, the market has dropped 20 percent or more from its peak 15 times.
While the market rebounded to its peak within a few years in most of those cases, the worst crashes kept investors in the red for much longer.
Investors hit by the double whammy of the dot-com bust and the 2008-09 global financial crisis did not fully recover their losses for nearly 13 years.
But if there is one thing that financial experts are practically unanimous on, it is that attempting to time the market is a fool’s errand.
“One reason that waiting to see a trend is so dangerous is that some of the best up days in the market follow soon after the worst down days,” Angel said.
“The best year in US stock market history was in 1933, at the depth of the Great Depression. The market had gone down so much, that when it became clear that a recovery was under way, the market rallied rapidly.”
Burton Malkiel, a professor of economics at Princeton University, said investors who feel they are at the limits of their risk tolerance are better off shifting the balance of their portfolios towards lower-risk assets, such as bonds and holding onto more cash than trying to time the market.
“You will invariably get it wrong and in the long run the US will eventually straighten things out,” he said.
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