“By many measures, for example, equity prices are fairly highly valued.” Jerome Powell, Tuesday, September 23, Speech to the Providence Chamber of Commerce.
That recent comment by Fed Chair Jerome Powell helped spark the recent three-day selloff in equities. No, it wasn’t just that comment alone, but those words did add some worry for investors.
Powell isn’t the only one thinking this though, as the recent Bank of America Global Fund Manager Survey showed that a record 58% of respondents viewed global equity markets as “overvalued.”
Irrational Exuberance 2.0?
The comments reminded many of us old timers of Alan Greenspan’s now infamous ‘irrational exuberance’ speech on December 5, 1996. All the S&P 500 did after that was double over the next three years, with the tech-heavy Nasdaq doubling several times into early 2000. Yes, stocks crashed soon after, but still, this famous quote from John Maynard Keynes rings a bell here: “Markets can remain irrational longer than you can remain solvent.”
Stocks are somewhat pricey in some areas (as we will discuss more below), but earnings drive long-term stock gains and those are still quite strong. Here’s the latest S&P 500 earnings estimates from FactSet. Up, up, and away comes to mind. Forward earnings are no more predictive than valuations, but they provide a powerful fundamental reason why markets have been advancing.
Valuations Aren’t Meant for Timing
Valuations aren’t the best timing tool. As a matter of fact, they’re really not a timing tool at all and the data has backed that up, as we show below. Back in 2014, all we heard was how Robert Shiller’s cyclically adjusted price-to-earnings ratio (“CAPE”) was extremely pricey, and doom was coming. Trust me, anyone with even a small bearish inclination was talking about it, and they were worried that stocks were going to perform poorly over the next decade.
Some even called it “The New Normal,” which meant to expect lower than average returns. Heck, Bill Gross (aka the Bond King) said several years earlier in 2012 that “the cult of equity is dying,” although I guess we shouldn’t be too frightened when a bond guy criticizes stocks. And he couldn’t have been more wrong—instead all we’ve seen is one of the greatest decades ever for stock investors.
Do valuations matter? Well, going out one year the answer is a resounding no, as the r-squared (the statistic that measures how much one variable helps explain another) between the price-to-earnings ratio (“PE”) and S&P 500 performance a year later is 0.00. In other words, there has been no relationship between valuations and S&P 500 returns over the next year. Yes, if you go out further (say five or 10 years) you will find more explanatory power. Still, if you were a bull back in the mid-2010s it is hard not to remember how wrong those bears have been the past 10 years, so by no means is a ‘high’ valuation by itself a reason to avoid equities.
What To Do?
Listen, if you have to avoid US equities because you think they are too pricey, then do what you have to do. But we’d suggest looking a little deeper, as it is really the technology and communications groups that are pricey (and also the most profitable) and various other parts of the market are quite reasonable. If you want lower valuations, you can also diversify with a nice bucket of global equities. All year we’ve been beating the drum to have a diversified portfolio, versus simply being just into US large caps, which has been the most rewarded part of the market the last decade.
Now What?
Here is some more positive thinking.
First up, the fourth quarter is historically quite strong and when stocks are doing well going into it, it has done even better. This quarter is historically higher 80% of the time and up an impressive 4.2% on average. Both are the best of the four quarters of the year.
But when the S&P 500 hits a new high in September (like it has done eight times this year), the fourth quarter has been higher nearly 91% of the time (20 out of 22 times) and when the S&P 500 is up more than 10% year to date heading into the fourth quarter, the last quarter of the year has been green 14 out of the past 15 times.
Secondly, the S&P 500 is about to close up five consecutive months. It turns out five-month win streaks are historically quite bullish for continued strength. In fact, the S&P 500 has gained a year later after a five-month win streak an incredible 28 out of 30 times.
Is This Like 1929? Not Really
Here we go again. The crash guy has been let out of his box. The Wall Street Journal had an article this week, where a fund manager says he sees conditions akin to 1929, when stocks crashed. The “silver lining” here is that he thinks this is like the early part of 1929, when stocks continued to boom. Keep in mind that this fund manager essentially keeps buying tail-risk insurance that pays off big time if stocks crash sharply, so there’s a bit of “talking your book” here. As the article notes, the same person warned of “something really, really bad” over a year ago in July 2024. The S&P 500 has gained 23% since then.
You just can’t win. If stocks are going up, it just can’t be true and surely things are in a bubble. If stocks are going down, things will only get worse.
Still, there’s quite a bit of “bubble” talk recently, and questions about whether the market is stretched too thin. The first place we tend to look when we hear this is valuations, as valuations would be really stretched if this were a bubble. The forward PE of the S&P 500 is right now at 22.9x, which is certainly above even the first standard deviation when you look at the last 30 years of data. At the same time, pinpointing a bubble in real time is really hard. Right now, things do look expensive but it’s hard to say whether or not it’s a bubble, let alone when the bubble will collapse even if it were one.
Another approach is to look at what’s driving markets returns. The S&P 500 has gained 14.3% year to date (through September 24), and we can break that down into gains from profit growth, multiple growth (change in valuation), and dividends:
- Earnings growth contribution: +7.9% points
- Multiple growth contribution: +5.3% points
- Dividends: +1.1% points
In short, 9% points of the index’s return has come from profits, both retained and distributed (dividends), or about 63% of the overall return. In fact, we can break the earnings growth contribution into the contribution from sales growth and margin expansion:
- Sales growth contribution: +5.1% points
- Margin expansion: +2.8% points
This tells you that 1) the economy continues to grow, which is why sales are growing; and 2) companies have the ability to expand margins as sales grow, that is, they have “operating leverage.” Keep in mind that all this is happening while there’s a lot of uncertainty about tariff policy and the interest rate outlook.
In fact, if you zoom out over the last 5.5+ years, (2020 – 2025 to date), the S&P 500 has gained 125%. That return can be broken down into returns from:
- Earnings growth: +76% points
- Multiple growth: +30% points
- Dividends: +19% points
But Is There a ‘Profit Bubble?’
As I noted earlier, year-to-date returns for the S&P 500 have mostly been driven by profits. The S&P 500’s forward 12-month earnings per share (EPS) is currently at $292, up almost 8% from the start of the year. As you can see in the chart below, there’s been no let-up in market expectations of profit growth over the last few months. (There was brief hiccup in April amid the tariff chaos.) The line keeps going up and to the right, which is why stocks are going up and to the right.
This also raises the question as to whether there’s a “profit bubble.” The key question is really what’s driving profits, and from an aggregate macro perspective, a big driver is investment spending, assuming consumer savings and government deficits don’t change (though rising fiscal deficits have also boosted aggregate profits recently).
The idea with investment driving profit growth is that one company’s spending (or investment) is another company’s income (and profit). And right now, there’s a lot of investment, albeit focused on a particular area: artificial intelligence (AI). The investment, or capital expenditures (capex), in this space is enormous, and is even having a big impact on GDP growth despite being a relatively small part of the overall economy. In fact, over the first half of 2025, AI-related spending (hardware and software) contributed an average of 1.0% point to GDP growth. That’s more than the contribution of 0.6% points from consumer spending, which makes up close to 70% of the economy.
Cash-rich tech companies are going on a capex spending spree, providing a crucial boost to the economy, and that does not look like it’s ending soon. And it’s also providing a big boost to the profits of these large tech companies. Some examples:
- Nvidia just committed to spending $100 billion on OpenAI to supply it with data center chips, as well as $5 billion in Intel.
- OpenAI is also expected to buy $300 billion in computing power from Oracle over five years.
- CoreWeave signed a 5-year deal with OpenAI worth $11.9 billion.
- Google struck a 6-year cloud computing deal with Meta worth over $10 billion.
- Amazon made another $4 billion investment into OpenAI competitor Anthropic (which makes the AI tool “Claude”), doubling their investment.
- “Stargate”, a joint venture between OpenAI, Oracle, and SoftBank, is expected to invest $500 billion in data centers over the next several years.
This AI-related infrastructure boom is larger than what we saw during the telecom and broadband buildout in the late 1990s, and about as large as the railroad boom back in late 1800s. With the railroad boom, the companies built too many lines too fast, creating duplicate capacity. These sat idle for a while (hence the crash after the boom) but eventually became useful once again as the economy expanded. With the telecom boom, companies laid a lot more fiber optic cables than was needed back then (and so these companies lost money), but this “dark fiber” became useful in later years, especially after all of us started streaming cat videos on YouTube and later spent evenings at home watching Netflix. The pattern we’ve seen has been:
- A massive capex boom
- Overbuilding
- A shake-out, leading to a crash
- Long-term benefit
The question right now is whether the current generation of data centers will actually lead to a long-term benefit. One big difference is that the lifespan of this AI infrastructure is much shorter than say railroads and broadband fiber optic cables—datacenters that are deployed with the latest, most sophisticated chips (which are used to train AI models and provide responses to our AI prompts) are likely going to be near obsolete in 3-4 years as chip technology advances. The depreciation of these assets happens much faster, in contrast to what we saw with railroads or telecom. (“Moore’s Law,” first stated in 1965, noted that the number of transistors in an integrated circuit had been doubling about every two years. That observation has continued to hold roughly true the last 60 years.)
Another difference is that there are only a handful of players are involved in the current AI boom, since only these large companies have the funds and scale to operate at these levels. In fact, that also gets to the fact that these companies are enormously profitable and have cashflows from other business lines (ads for Google and Meta, and cloud storage for Microsoft and Amazon). So, this is not being driven by debt and levered balance sheets, at least not yet. With the railroads and telecom there were a lot more players, and more widespread vulnerability—land grants and government subsidies boosted the railroad boom while deregulation (including the 1996 Telecom Act) spurred competition and capital spending in telecom in the late 1990s.
Of course, it’s one thing to recognize that there’s a lot of capex spending on AI right now, and a whole other thing to figure out the timing of when it may end, let alone the investment impact. Keep in mind that the big companies don’t have any intention to pull back right now. Here’s Mark Zuckerburg, founder of Meta:
If we end up misspending a couple of hundred billion dollars, I think that that is going to be very unfortunate obviously. But what I’d say is I actually think the risk is higher on the other side. If you if you um build too slowly and then super intelligence is possible in 3 years, but you built it out assuming it would be there in 5 years, then you’re just out of position on what I think is going to be the most important technology that enables the most new products and innovation and value creation and history.
And Larry Page over at Google:
I’m willing to go bankrupt rather than lose this race. Everybody is focused on ROl, but the people making the decisions are not.
There’s a reason why we emphasized diversification in our 2025 Midyear Outlook: Uncharted Waters. In some ways, even the current AI spending/investment boom is “uncharted waters” and now may be the time to pay attention to principles of good portfolio construction, especially diversification, rather than being concentrated in any particular area of the market.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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