It's amazing what a difference a year -- or even a few months -- can make on Wall Street. In 2021, the mature-business-packed Dow Jones Industrial Average (^DJI 0.40%), broad-based S&P 500 (^GSPC 1.02%), and innovation-driven Nasdaq Composite (^IXIC 2.02%), all galloped to record highs. In 2022, they all plunged into a bear market, with the Nasdaq truly taking it on the chin with a 33% loss.
But just five-and-a-half months into 2023, two of the three major indexes are, once again, off to the races. The S&P 500 and Nasdaq are higher by 15.3% and 31.7%, respectively, through June 15, with the Nasdaq 100 -- an index comprised of the 100 largest nonfinancial companies listed on the Nasdaq exchange -- higher by 39.1%.
Image source: Getty Images.
Is the stock market in a bubble?
By one rule of thumb, a 20% bounce from bear market lows signals the start of a new bull market. With the exception of the iconic Dow, which wasn't hit nearly as hard in 2022, the S&P 500, Nasdaq Composite, and Nasdaq 100 have all bounce more than 20% from their 2022 lows, and by this definition entered a new bull market.
But when examined in a different light, Wall Street appears to have shifted from a bear market to a bubble in the blink of an eye.
To be completely fair, it's incredibly difficult to spot bubbles prior to, and even during, their occurrence. It's only after a bubble pops that investors can look back with confidence and note that valuations and investors' emotions got out of hand.
In certain respects, the stock market doesn't meet the traditional definition of being in a bubble. For instance, the forward-year price-to-earnings (P/E) ratio for the benchmark S&P 500 stood at nearly 19 on June 15. That's toward the midpoint of the forward P/E valuation range of the S&P 500 over the past 25 years and, by itself, doesn't raise any red flags.
However, if we take a closer look at market breadth, the history of next-big-thing investments, and another closely watched valuation metric, the story changes.
Poor market breadth signals Wall Street may be in a precarious spot
Although the S&P 500 and growth-focused Nasdaq Composite are decisively higher this year, only a very small number of megacap stocks are responsible for this move.
As you can see above, Apple (AAPL -0.35%), Microsoft, Amazon, Nvidia (NVDA 6.18%), Alphabet, Tesla, Netflix and Meta Platforms have soared this year. Collectively, these seven companies and eight securities (including Alphabet's two share classes) account for 27.56% of the weighting for the S&P 500. Remove these eight components from the equation and the S&P 500 would barely be up on a year-to-date basis.
Now, don't get me wrong, larger companies should have more weighting within the index. But the vast outperformance we've seen from seven of the largest publicly traded companies in the U.S., compared to the other 490-plus components in the S&P 500, is eyebrow-raising and a clear sign of poor market breadth.
What's more, the valuations for some of these seven stocks are well outside of their historic norms. For instance, investors are paying a multiple of 31 times fiscal 2023 earnings (Apple's fiscal year ends in late September) to own shares of Apple. That's more than double the average year-end P/E ratio investors were paying to own shares of Apple from the start of 2013 through 2018. Worst of all, Apple's sales and profits are expected to decline by a low-single-digit percentage this year, even with above-average inflation as a tailwind.
It's a similar story for Nvidia. Between 2013 and 2015, investors were buying shares of this graphics processing unit (GPU) giant for between 11-and-17-times cash flow. Following a near-tripling in its shares this year, Nvidia is priced at a nosebleed 156 times its trailing-12-month cash flow.
Image source: Getty Images.
Next-big-thing investments have a way of (initially) disappointing
Another concern for Wall Street is what's been driving the rally in the aforementioned seven companies: artificial intelligence (AI).
AI describes the use of software and systems to handle tasks that humans would normally oversee. What makes AI so intriguing is the incorporation of machine learning, which allows software and systems to evolve over time and become more efficient at their tasks. AI has broad application in virtually all sectors and industries, with PwC forecasting a $15.7 trillion AI-driven economic impact by 2030.
We've certainly seen tangible evidence of AI driving enterprise demand. Nvidia, which accounts for the lion's share of AI-focused GPUs being used in data centers, guided for $11 billion in fiscal second-quarter 2024 sales, which blew Wall Street's expectation of $7.2 billion in sales out of the water.
Nevertheless, next-big-thing investments have a terrible track record of leading FOMO (fear of missing out) investors to sizable losses. While virtually no one is denying that AI represents an intriguing opportunity for businesses to take advantage of, the actual demand for AI products and services over the next couple of years is almost certain to fall short of current lofty forecasts.
If we look back 30 years, every single next-big-thing investment went through an initial bubble period before either taking off for good or completely fizzling out. Whether it was the internet, business-to-business commerce, genome decoding, cannabis, 3D printing, or the metaverse, every innovation needs time to mature. AI isn't a case of "this time will be different."
The Shiller P/E ratio is in dangerous territory
From a valuation perspective, the most damning evidence of all that we might have jumped straight from the 2022 bear market into a stock market bubble is the Shiller P/E ratio, which is also commonly referred to as the cyclically adjusted price-to-earnings ratio (CAPE ratio).
S&P 500 Shiller CAPE Ratio data by YCharts.
Most investors are probably familiar with dividing a company's share price into its trailing-12-month earnings to arrive at its P/E ratio -- i.e., the most-popular valuation metric. The S&P 500's Shiller P/E ratio is different in that it's based on average inflation-adjusted earnings from the previous 10 years. Using 10 full years of earnings data helps minimize potentially wild one-year swings in corporate earnings to get a cleaner picture and how cheap or expensive the S&P 500 is.
On June 15, the Shiller P/E ratio closed at 30.9. Not only is this well above its median of 17.03, when back-tested to 1870, but it also represents dangerous territory, at least based on what history tells us.
Since 1870, there have only been five prior instances where the Shiller P/E surpassed 30. In all five of those instances, the Dow Jones or S&P 500 lost between 20% and 89% of their respective value. The implication here is that perceived-to-be extended valuations always, eventually (key word!), get reined in by Wall Street. The sixth instance of the S&P Shiller P/E surpassing 30 occurred this year.
The one caveat to the S&P 500's Shiller P/E ratio surpassing 30 is there's no rhyme or reason to how long valuations can stay extended. Sometimes it takes a matter of weeks or months before the benchmark index sheds 20% or more of its value. In other occasions, it's taken years before the valuation bubble burst. In other words, the Shiller P/E ratio isn't a timing tool, but it can serve as a warning that valuations are in bubble territory.
Though it's incredibly difficult to spot bubbles before they pop, there is evidence to suggest that we're in, or near, a stock market bubble.
