Different valuation models tell conflicting stories about the US market. The Shiller CAPE ratio suggests extreme overvaluation near dot-com bubble highs. However, a reverse DCF model calculating the implied equity risk premium shows the market is only moderately valued, creating a confusing picture for investors.
Related Insights
The Shiller P/E ratio, a measure of long-term market valuation, has only crossed 40 three times: 1929, 1999, and today. The first two instances preceded major market crashes (The Great Depression, Dot-com Bust) and were followed by a decade or more of flat or negative real returns for investors.
Historically, US earnings outgrew the world by 1%. Post-GFC, this widened to 3%. Investors have extrapolated this recent, higher rate as the new normal, pushing the US CAPE ratio to nearly double that of non-US markets. This represents a historically extreme valuation based on a potentially temporary growth advantage.
With the S&P 500's Price-to-Earnings ratio near 28 (almost double the historic average) and the Shiller P/E near 40, the stock market is priced for perfection. These high valuation levels have historically only been seen right before major market corrections, suggesting a very thin safety net for investors.
Today's high S&P 500 valuation isn't a bubble. The market's composition has shifted from cyclical sectors (where high margins compress multiples) to mature tech (where high margins expand them). This structural change supports today's higher price-to-sales ratios, making the market fairly valued.
History shows that markets with a CAPE ratio above 30 combined with high-yield credit spreads below 3% precede periods of poor returns. This rare and dangerous combination was previously seen in 2000, 2007, and 2019, suggesting extreme caution is warranted for U.S. equities.
Current market multiples appear rich compared to history, but this view may be shortsighted. The long-term earnings potential unleashed by AI, combined with a higher-quality market composition, could make today's valuations seem artificially high ahead of a major earnings inflection.
While the S&P 500's price-to-earnings ratio is near dot-com bubble highs, the quality of its constituent companies has significantly improved. Current companies are more profitable and generate nearly three times more free cash flow than in 2000, providing some justification for today's rich valuations.
The stock market is not overvalued based on historical metrics; it's a forward-looking mechanism pricing in massive future productivity gains from AI and deregulation. Investors are betting on a fundamentally more efficient economy, justifying valuations that seem detached from today's reality.
The argument against a market top is that high multiples are justified. In an era of sustained currency debasement, investors must hold assets like stocks to preserve purchasing power. This historical precedent suggests today's valuations might be a new, structurally higher baseline.
Contrary to a common myth, high equity valuations do not reliably revert to a historical mean. An analysis of 32 different valuation scenarios found only one case of statistically significant mean reversion. Structural economic shifts, like reduced GDP volatility since the 1990s, justify higher sustained valuation levels.
