The opening numbers are displayed at the opening bell of the Dow Industrial Average at the New York Stock Exchange on Dec. 6, 2018. (Credit: BRYAN R. SMITH/AFP/Getty Images files)
As we enter 2025, the general consensus is that stocks are set to deliver another year of decent returns. Most strategists contend that we will be in a goldilocks environment characterized by positive readings on economic growth, profits, inflation, and rates. This sentiment is particularly evident in the current valuation level of the S&P 500 Index.
Regardless of which metric one uses, the index is extremely elevated relative to its historical range. Interestingly, U.S. stocks are an outlier when compared to other major markets (including Canada), which are trading at valuations that are in line with historical averages.
The best of times and the worst of times
Unfortunately, the history books are quite clear about what can happen to markets that attain peak valuations. The four largest debacles in the history of modern markets were all preceded by peak valuations.
In 1929, the U.S. stock market traded at the highest PE multiple (or price-to-earnings ratio) in its history up to that time. This lofty multiple presaged the worst 10 years in the history of the U.S. stock market.
In 1989, the Japanese stock market was trading at 65 times earnings. The aggregate value of Japanese stocks exceeded that of U.S. stocks despite the fact that the U.S. economy was three times the size of its Japanese counterpart. Soon after, Japanese stocks suffered a particularly prolonged and steep decline.
In early 2000, the S&P 500 Index, aided and abetted by a tremendous bubble in technology, media, and telecom stocks, reached the highest multiple in its history. Not long after, the index suffered a peak trough decline of roughly 50 per cent over the next few years.
In early 2008, the S&P 500 stood at its highest valuation in history, with the exception of the multiples that preceded the great depression and the tech wreck. The ensuing mess brought the global economy to the brink of collapse and required an unprecedented amount of monetary stimulus and government bailouts.
The bottom line is that markets have historically been a very poor predictor of the future. The loftiest valuations have not just been followed by tough times, but by the worst of times.
The common feature
There is one common feature to these sorrowful tales of peak multiples that ended in tears. In each case, peak valuations followed a prolonged period of near-perfect environments characterized by strong economic and profit growth.
The years before the Great Depression entailed an economy that had not only been growing but booming.
Before 1989, the Japanese economy enjoyed decades of torrid growth, prompting some economists and strategists to predict that it would eventually eclipse the U.S. economy.
In early 2008, the U.S. economy was being propelled by a real estate bubble underpinned by an “it can only go up” mindset.
The S&P 500 Index currently stands at its highest multiple in the postwar era, except for the late 1990s tech bubble. Optimists justify this development by pointing to what they believe to be a rosy future with respect to the U.S. economy, earnings, inflation, and interest rates. Sound familiar?
The historical pattern of shiny new toys
Every bubble has been spurred by a miraculous new technology or invention that promises to change the world. Canals, railroads, automobiles, electricity, and telephones were all enablers of euphoric, “this time it’s different” mentalities that led to bubbles and their painful aftermaths. More recently, in the late 1990s the internet captured the imagination of investors, who widely believed there was no price that was too high to pay for the unlimited profit potential of companies that had exposure to this new phenomenon.
Like its predecessors, artificial intelligence (AI) promises to transform economies by enabling quantum leaps in productivity and efficiency. AI-related companies are widely believed to possess nearly unlimited growth potential, which is clearly reflected in their valuations.
It’s not as easy as it seems:
Historical patterns aside, being a contrarian has never been a painless exercise.
The Japanese market had never traded above 25 times earnings when it first breached that level in the mid-1980s. Still, this valuation ultimately proved unsustainable and Japanese stocks went from overvalued to become the mother of all bubbles as they peaked at 65 times earnings in late 1989.
When the S&P began to look dangerously overvalued relative to history at the end of 1997, it nonetheless proceeded to crazy town, rising another 62.2 per cent by late March of 2000 before the party came to an abrupt end.
The upshot is that although the S&P 500, and more specifically AI-related, megacap technology stocks, may prove to be overvalued, this by no means implies that they may not have significant upside over the short- to medium-term.
Here’s the punchline
Allow me to disclose my personal investing biases. First, I like to play the odds as dictated by historical data and patterns. Second, I believe that an opportunity missed is less bad than a loss. Relatedly, if I miss an AI-fuelled frenzy that drives continued U.S. outperformance, I can live with that. What I cannot abide is doing nothing and risking the significant underperformance that has historically followed periods of extreme valuations.
To be clear, I am not advocating for investors to aggressively de-risk their portfolios and significantly reduce their overall allocation to equities. However, I do believe it would be prudent to become more defensive at the margin within equity portfolios.
While I have no strong convictions regarding what markets will do over the short term, I do believe that those with a medium- to long-term horizon would be well-served to reduce their exposure to megacap tech stocks, and by extension to the S&P 500 Index. On the flipside, investors should shift some of their U.S. holdings into more value-oriented U.S. stocks, and more generally into non-U.S. developed equities.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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