Are the Stock Market's All Time Highs Justified?
An even-handed analysis of the factors that will decide whether we can go further from here
After a bad start to the year in which we saw the stock market enter correction territory (defined as a 10+% loss from the high) and even very briefly slip into bear market territory (20+% down from the high), the S&P 500 bounced back and was setting all time highs by late June, which have continued into July.
The purpose of this piece will be to explore not just whether the market’s all time highs are justified, but whether it makes sense for it to continue going higher. As the sharp change between April and June shows, timing the market is a futile thing, because reversals can materialize in unexpected situations. But if you’re following an active rather than passive strategy, you may want to diversify your assets (see my list of recommendations at the end) if you have a strong conviction that the market is overvalued.
Rising prices
As an introductory remark, I would like to say that while the market is generally considered overvalued by both experts and laymen, there is one point that neither frequently considers. That is the general rise in the price level, which usually is relatively mild but became more significant during and after the pandemic. In the previous 10 years, CPI has risen 35%. (Almost anyone who has been buying things in that span of time can confirm that number grossly underestimates the general increase in prices.) Higher prices mean higher revenue for companies, which should translate to higher stock prices. Over that 10 years, the median home price has risen 44%. Within that context, the S&P’s tripling seems slightly less remarkable, but is still somewhat manic.
In the time that I’ve been investing I’ve generally erred toward bearishness. However, a key aspect of successful investing is the ability to think rationally, no matter one’s personal bias. To that end, instead of a biased diatribe, I have decided to list both headwinds and tailwinds for the stock market separately and let my readers decide which outweighs the other.
Tailwinds
BBB: The passage of Trump’s “big beautiful bill”, despite its long-term downsides (the deficit, cuts to programs people depend on, etc.) will probably be positive for the stock market. The permanent reduction in income taxes and removal of taxes on tips and overtime should lead to more disposable income, which means more investment in 401(k)s and investment accounts. The bill also includes various more obscure corporate tax credits.
401ks/passive investing/meme investing: I’ve written before about passive investing, the strategy of investing in low-cost ETFs that are linked to broad indices. The risk of passive investing is that needed price adjustments don’t happen because money is always flowing in, rather than in and out, of securities. In my opinion, passive investing has been a large tailwind since it started to replace active investing in earnest in the 2000s, and there is no sign that this trend will reverse. Additionally, Americans are more exposed to stocks through their 401(k)s and “meme”/retail investing, two more sources of capital inflows.
Consumer optimism and inflation tolerance: Consumers are generally optimistic, as we wrote about here. Since the pandemic, consumer spending has generally been very strong, to the point where the finance blogosphere has even chastened American retail buyers “drunken sailors.” This is good news for companies who have a desire to raise revenue. So is the fact that as opposed to the pre-pandemic days, when consumers watched prices carefully, they are now expecting inflation. That means the big companies that make up our stock portfolios can sneak in price hikes even if their underlying costs haven’t risen, and they’re employing busy teams who figure out exactly how much they can get away with.
Some automation with AI will likely be possible: The above point explains how companies can continue to raise revenue. Their other option to raise profits is to cut costs, which should be possible to some extent with AI as the technology grows. Customer service, sales, and even some coding jobs may be on the chopping block as large language models’ skills increase.
Headwinds
Tariffs: I’ve written about the downsides of Trump’s tariff plan and the market seemed to agree with me in April, before rebounding as it began to seem more likely that the tariffs were a negotiating tool rather than a long-term policy. However, there is still a risk that these stay on for a long time; if they do, they both force companies to eat some cost increases, and lower consumer demand as prices rise.
Valuation: It’s not just that the index has tripled in 10 years, which is a potentially unsustainable gain. It’s also that the aggregate S&P 500 P/E ratio is at levels seen only a few times before in our history. And each time it was at those levels, it was followed by a quick drop. Additionally, the Buffett Indicator, which compares stock market valuation to GDP, shows historically large overvaluation.
Problems with concentration: While it can be a strength at times, the S&P’s concentration can also be a weakness. Since the S&P is a market cap weighted index, meaning each component’s weight is determined by its market value, a few large stocks make up a significant percentage of the index. The top 10 stocks in the index make up 36% of its value. All but one of these is a tech company. Should there be even a slight pullback in our ongoing tech boom, the whole index could be dragged down precipitously.
Note: When this chart was circulated, Nvidia was much smaller than it is now, so the gap is probably now even more extreme.
Overblown AI expectations: Speaking of pullbacks in tech, I’ve written at length here about the potential for AI to be a bubble. While the technology is impressive and promising, stocks are inflated to the point where it needs to meet 100% of expectations. If that doesn’t happen, the consequences for the stock market could be severe.
Lack of innovation: Besides ChatGPT, few life-changing innovations have emerged since the iPhone’s release in 2007. Cars, food, appliances, and even personal tech have remained much the same for years. Large businesses funnel money into stock buybacks rather than new product development. New products are one of the best ways to increase revenue, so this is a major concern.
Yields: For over a decade, the rebound in the stock market after the Great Recession was driven by a phenomenon called “TINA” (there is no alternative). To stimulate the economy, the Fed had cut interest rates to historically low levels, forcing investors away from bonds and into stocks. Since the pandemic, this has changed, with Treasuries offering competitive rates. Right now, there is optimism about the Fed cutting, with interest rate wagering markets predicting 2-3 cuts by the end of the year. But this optimism has been mislaid many times before, so yields could stay high and compete with stocks.
I’ll let you make up your own mind about whether the list of tailwinds outweighs the list of headwinds. It’s clear that there are plenty of both, and betting against the US stock market, over the long run, has been a fool’s errand. But knowledge of the risks, to prevent risky over-allocations, is always wise. If you think the market is overvalued, consider putting some of your hard-earned cash in proven alternatives: bonds, high yield savings accounts, gold, foreign stocks, or REITs.