The extraordinary gains in U.S. equities since early 2023 have been driven increasingly by valuation expansion, raising concerns that the artificial intelligence boom could be approaching a more speculative stage, according to Capital Economics.
Chief Economic Adviser John Higgins noted that the S&P 500’s cyclically adjusted price-to-earnings ratio has risen sharply over the past two and a half years, moving above 40 for the first time since the period preceding the collapse of the dotcom bubble.
The ratio has climbed by more than 12 points since the start of 2023, a move that Capital Economics believes deserves close attention.
According to Higgins, the CAPE is now at “a level last seen before the dotcom bubble burst.”
Valuations Have Driven Most of the Rally
The firm estimates that more than two-thirds of the S&P 500’s gains since early 2023 can be attributed to rising valuations rather than improvements in underlying earnings.
For that reason, Higgins argued that the market may already be showing “one sign that we may be in the ‘blow-off’ phase of the AI-fuelled rally.”
Other Indicators Suggest Less Excess
Not all valuation measures point to the same degree of risk.
The forward 12-month earnings multiple currently stands near 21, well below the levels seen during the technology bubble of the late 1990s.
Likewise, the forward three-year multiple remains considerably lower than its dotcom-era peak.
These figures suggest that while valuations are elevated, the situation may not yet match the extremes experienced during previous market bubbles.
Structural Concerns Remain
Capital Economics nevertheless remains cautious.
The firm highlighted concerns surrounding the sustainability of recent profit growth, unusually high technology investment spending relative to economic output, and the historically elevated valuation of U.S. non-financial corporations compared with their underlying net worth.
Together, these factors suggest investors may be assigning increasingly optimistic expectations to future growth.
Future Returns Could Be More Modest
The firm also pointed to the excess CAPE yield as evidence that long-term return prospects may be less attractive than recent performance suggests.
Historically, the measure has provided a useful indication of future stock returns relative to Treasury bonds.
Current readings imply that equities may generate below-average excess returns over the next decade.
While Capital Economics is not calling for an immediate end to the rally, it believes investors should remain mindful of valuation risks as enthusiasm surrounding artificial intelligence continues to drive markets higher.
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