Key Points
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Several catalysts, spearheaded by the rise of artificial intelligence (AI), recently sent the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite to record highs.
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Stock valuations are otherworldly and doing something that’s been observed only once before in 155 years.
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The AI stocks that spurred this historic rally are likely to be its eventual downfall.
Despite a period of volatility in March, it’s turning out to be another banner year on Wall Street. In recent weeks, the iconic Dow Jones Industrial Average (DJINDICES: ^DJI), broad-based S&P 500 (SNPINDEX: ^GSPC), and technology stock-propelled Nasdaq Composite (NASDAQINDEX: ^IXIC) all rocketed to record highs.
There’s a lot piquing investors’ interests at the moment, including:
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The advent and proliferation of quantum computers
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The imminent initial public offering of SpaceX
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Better-than-expected corporate earnings
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Record S&P 500 share repurchases
But as history shows, the stock market doesn’t move higher in a straight line. While the Dow, S&P 500, and Nasdaq Composite absolutely have increased in value over the long term, Wall Street can take investors on some wild rides over shorter timelines.
A New York Stock Exchange floor trader looking up in bewilderment at a computer monitor.
Image source: Getty Images.
Based on one virtually unprecedented event that we’re witnessing right now, we appear to be on the verge of a big move in stocks.
Stock valuations are otherworldly
While there are several reasons to question the sustainability of Wall Street’s bull market rally, including record margin debt, a historically divided Federal Reserve, and the ongoing effects of Trumpflation, it’s the stock market’s otherworldly valuation that should give investors pause — especially in light of history.
To state the obvious, valuing individual stocks or the broader market isn’t black-and-white. Since value is entirely subjective, what one investor considers pricey may be a bargain to another. The subjectivity of evaluating and valuing stocks is one of the main reasons short-term moves in the Dow, S&P 500, and Nasdaq Composite are so challenging to predict with any sustained accuracy.
But there is a time-tested valuation measure that does an exceptional job of cutting through investors’ emotions and subjectivity to provide an apples-to-apples comparison of broad-market valuations: the Shiller Price-to-Earnings (P/E) Ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE Ratio).
When most investors “value” a stock or the broader market, they use the traditional P/E ratio, which is based on trailing 12-month earnings per share (EPS). The problem with the P/E ratio is that it loses its usefulness during recessions when EPS can turn negative.
This is where the Shiller P/E can shine. It’s based on average inflation-adjusted EPS over the trailing 10 years. Accounting for a full decade of EPS history ensures it’s useful across all economic climates.
The S&P 500’s Shiller P/E Ratio has averaged approximately 17.4 when back-tested to January 1871. But as of the closing bell on May 22, the CAPE Ratio was tipping the scales at 42.04 — more than twice its 155-year average.
What we’re witnessing is virtually unprecedented. The only other time the Shiller P/E has reached 42, aside from the present, was in the months leading up to the bursting of the dot-com bubble in March 2000. In December 1999, the S&P 500’s CAPE Ratio topped out at 44.19.
Historically, expensive Shiller P/E ratios have proven disastrous for Wall Street. Since January 1871, there have been six instances, including the present, where the Shiller P/E exceeded 30 during a continuous bull market rally. The previous five occurrences all eventually ended with the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite losing 20% or more of their value.
The one notable limitation of the CAPE Ratio is that it’s not a timing tool. Sometimes, stocks stay pricey for a matter of a few months, and other times they’ve defied gravity for up to four years (e.g., the dot-com bubble).
Although this valuation tool can’t predict precisely when the music will stop on Wall Street, historical precedent points to a meaningful downturn in the not-too-distant future.
A twenty dollar bill paper airplane that’s crashed and crumpled into a financial newspaper.
Image source: Getty Images.
The AI stocks that led this rally will likely be responsible for its downfall
Among the laundry list of catalysts fueling this virtually unprecedented surge in stock valuations is the rise of AI. Empowering software and systems with the tools to make split-second, autonomous decisions is a technology with multitrillion-dollar implications worldwide.
In some ways, AI stocks sidestep the criticisms often bestowed on dot-com companies. Whereas most dot-com era companies lacked profitable, foundational operating segments, this isn’t the case with the dozens of companies at the forefront of the AI revolution. All members of the “Magnificent Seven” were profitable before AI became the hottest thing since sliced bread, and they’re leaning on their operating cash flow to fuel AI data center build-outs.
There’s also no adoption issue with AI. Nvidia‘s data center revenue is through the roof, thanks largely to its superior graphics processing units. Meanwhile, customizable rack server specialists, along with memory and storage companies, are all enjoying jaw-dropping demand and exceptional pricing power.
But there is one unmistakable similarity between the dot-com bubble and AI that can sink the ship: optimization.
Before the dot-com bubble burst, businesses were adopting internet solutions with open arms. However, it took more than half a decade for businesses to figure out how to optimize the internet to maximize sales and profits.
While AI data center infrastructure spending is off the charts, businesses aren’t particularly close to optimizing this technology to maximize sales and profits. History has shown time and time again that investors persistently overestimate the optimization of game-changing technologies — and absolutely nothing suggests, thus far, that AI is the exception to this unwritten rule.
When the AI bubble bursts, is when the Shiller P/E Ratio will have peaked. More than likely, the AI companies that led this historic bull market are the ones that’ll be pointed to for its eventual downfall.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.
