1. Some investors fear a bubble—but the data doesn’t support it
All historical market bubbles have been marked by high valuations—but not all periods with high valuations have been bubbles. I think we’re in the latter scenario.
Some investors highlight the S&P 500® Index’s high cyclically adjusted price-to-earnings (CAPE) ratio, a metric that divides current stock prices by the last 10 years’ inflation-adjusted earnings. They point to historical data showing that, on average, high CAPE ratios have been followed by weak 10-year returns. And they note that the market’s current CAPE ratio of 40 is the highest it’s ever been outside of the dot-com bubble of the late 1990s.
All that is true. But my analysis finds that the most important factor affecting 10-year returns hasn’t been valuations—it’s been whether the period ended in a crisis. Since 1932, almost all the 10-year periods with high starting CAPE and weak returns concluded during either World War II, the inflationary recessions of the early 1980s, or the 2008 financial crisis. When 10-year periods began with high CAPE ratios and did not end during one of these crises, they delivered 10% average annualized returns—better than the market’s historical average.
The CAPE ratio at the start of each period did have an impact. Among 10-year periods that didn’t end in a crisis, those with low starting CAPE ratios had higher average returns. But whether a period ended in crisis mattered more. For example, 10-year periods that started with low CAPE but ended during a crisis had annualized returns of just 5%, on average.
The takeaway: The historical connection between high valuations, as measured by the CAPE ratio, and weak long-term returns may not be as strong as it appears.
Corporate overinvestment has historically been another sign of a bubble. Some investors worry that’s happening today, given huge companies’ investments in artificial intelligence (AI). But the data suggests otherwise. As of last year, S&P 500 companies were generally spending about 86% of their cash flow on capital expenditures (capex), on average. That’s actually significantly lower than the average pace of capex spending since 1962 (128% of cash flow). It’s also far lower than the levels seen during the dot-com bubble (when many companies were spending around 150% to 400% of cash flow on capex).
In the tech sector, annual cash flow exceeds capex by a wide margin, and it has since 2002. And the sector’s results are underpinned by powerful fundamentals: Technology company earnings have grown faster than the rest of the market’s since 2022.
