The equity market’s stellar comeback from its April lows has lifted valuations back to the peaks of this cycle. Much of the rebound has come on the back of a very favourable narrative around AI and a corresponding ramp-up of investment spending.
While there is no clear definition of a bubble, parallels to previous periods of exuberance can be drawn. Current valuations are not too far off the dot-com highs in the early 2000s. Similarly, credit markets are trading at risk spreads that are close to the lows over the past 25 years. One condition that allowed exuberance to build in equity markets in the early 2000s was the strong macro backdrop.
This would suggest that a substantial correction in risk markets only happens once the cycle starts to crack. While it is difficult to pin down the moment at which this will happen, the long-term implications of current valuations are more compelling. Past correlations with equity-risk premia and the cyclically adjusted price-to-earnings (PE) suggest single-digit annual returns in the years to come.
Market rally led by US tech
In recent weeks, the top end of the equity market has once again driven global and US equity performance. Led by the ‘Magnificent 7,’ the Nasdaq has surged 50% from its early April lows, boosting its year-to-date gains to 19%. This rally has been fuel led not only by the US administration’s shift on tariffs but also by surging capital expenditure (capex) announcements in recent weeks and a weaker US dollar in the first half of the year.
How does it compare to the dot-com boom?
One question circulating is whether the US equity market is edging into bubble territory. Since the term ‘bubble’ is not clearly defined, we compare the current market behaviour to the dot-com exuberance of the late 1990s and early 2000s. There are notable parallels but also key differences, leaving the market vulnerable yet less precarious than it was then. To provide a comprehensive picture, it is useful to compare today’s market with that period across various valuation metrics.
First, the Nasdaq Composite’s PE ratio remains far below the record levels of the dot-com era. In 2000, the PE soared above 70x, while today it is roughly half that level. This suggests the market is not overly stretched in terms of valuations. However, during the dot-com bubble, the Nasdaq included many young, unprofitable tech firms, which naturally inflated PE ratios due to low earnings. Today’s market is different: the Magnificent 7, all Nasdaq constituents, account for over 20% of S&P 500 earnings. Since the early 2000s, Nasdaq earnings have risen approximately 30x, while S&P 500 earnings have increased by about 5x. Thus, drawing parallels to the early 2000s is more appropriate using the S&P 500, which was a mature index and remains so today.
S&P 500 PE peaked similarly in 2000
Valuations paint a more concerning picture. The S&P 500’s PE ratio, based on 12-month forward earnings, stands at 23x – matching its 2021 cycle high and approaching the 25x peak seen during the dot-com boom. This suggests current valuations may be in dangerous territory, potentially ripe for correction.
A key condition of the dot-com boom, often overlooked, was the exceptionally strong economy at the time. Annualised GDP growth exceeded 4%, enabling markets to fully embrace the optimistic tech narrative and re-rate without interruption. The equity risk premium (ERP) – calculated as the 12-month forward earnings yield minus the 10-year Treasury yield – dropped deep into negative territory. Investors accepted an earnings yield below the risk-free rate, driven by expectations of a sharp earnings surge in the coming years. As history shows, this optimism was excessive.
S&P 500 ERP returns to zero
Last week for the first time since the early 2000s, the S&P 500’s ERP is back at zero, supported by a solid macroeconomic backdrop. While GDP growth is lower than in the dot-com era, it remains robust at around 3.
To justify current valuation levels, US earnings growth would need to accelerate significantly in the coming years. However, historical correlations with GDP growth suggest this is unlikely. Over the past 25 years, the correlation between US earnings growth and GDP growth has remained stable, despite rising net income margins. With US GDP growth projected to fall below 2% in 2026 due to waning fiscal support and slowing consumption, a sharp acceleration in earnings per share (EPS) growth seems improbable.
Weak long-term market returns predicted
Historically, the ERP has been a reliable indicator of medium-term market returns. In 2000, it accurately projected an average annualised S&P 500 return of about 0% over the next decade, with the S&P 500 total return index remaining flat from 2000 to 2010. At today’s ERP of 0%, an annualised return of just 4% is implied over the next 10 years. The Shiller PE ratio suggests an even lower annualised return of 2% over the same period. Notably, the Shiller PE was also accurate in the 2000s, forecasting a flat market.
Significant decoupling of 10-year returns from Shiller PE projections has occurred only twice in the past 40 years. First, in the 1990s leading up to the dotcom bubble, annualised returns reached 20% between 1990 and 2000, compared to an implied ~15%. Second, in 2015, the Shiller PE implied an annualised return of ~10%, while the US market delivered 14%. The 1990s decoupling eventually corrected, and it remains uncertain whether today’s equity market will follow a similar path or prove different.
Market looks increasingly bubbly
In conclusion, a bubble can usually only be determined with hindsight yet parallels to previous bubbles can be drawn. Current valuations would clearly suggest that the market is moving into bubble territory, but this does not necessarily mean that it will pop immediately. In 2000, the strong macro backdrop allowed exuberance to build over several years with the end of the cycle coinciding with the market sell-off. Long-term implications appear clearer. At current valuations, US equities will struggle to generate better than mid-single digit returns per year over the coming decade.
By Wolf von Rotberg, equity strategist at J. Safra Sarasin Sustainable Asset Management
