A recent analysis from Capital Economics suggests that the surge in U.S. equity valuations could signal the onset of a more speculative phase in the current artificial intelligence-driven bull market. In a note released recently, Chief Economic Adviser John Higgins pointed out that the cyclically adjusted price-to-earnings (CAPE) ratio of the S&P 500 has seen a significant increase, climbing more than 12 points since the beginning of 2023, and is now above 40. This level is reminiscent of the valuations prior to the dotcom bubble burst.
Capital Economics attributes much of the S&P 500’s advancement since early 2023—notably viewed as the starting point of the ongoing AI-fueled rally—to valuation expansion rather than solely to earnings growth. Specifically, the CAPE ratio is said to account for over two-thirds of the index’s gains during this period. Higgins interprets this trend as a potential indication that the market may be approaching what he describes as the “blow-off” phase in this AI-driven rally.
Despite the alarming signals from the CAPE ratio, other traditional valuation metrics appear to offer a more tempered perspective. The S&P 500’s forward 12-month price-to-earnings ratio has increased by less than four points since the rally began and now sits at about 21, remaining significantly below the dotcom-era peak of over 24. Similarly, the forward three-year earnings multiple has contributed only modestly to the market’s rise, currently standing near 17 compared to a peak above 22 during the tech bubble.
Nonetheless, Capital Economics maintains a cautious stance, primarily focusing on the CAPE ratio. They highlighted three main concerns: uncertainties surrounding the sustainability of recent earnings-per-share growth, high technology-related capital expenditures relative to GDP, and a near-record stock market value to net worth ratio among U.S. non-financial corporations. These elements suggest that current high valuations may be susceptible to downward adjustments if future growth expectations falter.
Looking ahead, Higgins also noted the implications of the excess CAPE yield, a measure that contrasts expected equity returns with Treasury yields, which has historically provided insights into long-term market performance. Current readings indicate that investors might encounter below-average excess returns from equities compared to government bonds over the next decade.
While Capital Economics does not foresee an imminent market downturn, the conjunction of elevated valuations and high growth expectations has prompted the firm to advocate for increased caution as the AI-driven market rally progresses.
