With the S&P 500 up roughly 8% year to date as of Tuesday morning, President Donald Trump’s second year back in office has been pretty good for stocks. And that’s despite the high levels of uncertainty surrounding his erratic trade policies, military activities, and attempts to interfere with the Federal Reserve’s independence.
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The resilience can be partially credited to the boom in generative artificial intelligence (AI), which has many of America’s largest companies pouring hundreds of billions into data center construction, sending chip and memory stocks soaring. But this won’t last forever. Let’s discuss some reasons why the current market rally could soon go into reverse.
Valuations are at historic highs
Trump’s booming stock market might be on borrowed time. And one of the biggest clues is the cyclically adjusted price-to-earnings (CAPE) ratio, a metric that compares stock valuations over 10 years to account for the business cycle. Right now, it stands at an eyewatering 41, which is higher than the peak of 32.6 reached during the Great Depression and second only to the all-time high of 44 reached during the dot-com bubble.
That situation has plenty of parallels with today. Back then, the tech industry was rapidly adopting a technology that had just burst into the mainstream, called the internet. And infrastructure companies boomed as demand for networking equipment rose. Meanwhile, a slew of highly speculative consumer-facing internet companies went public at high valuations, despite not demonstrating meaningful revenue or profit growth.
Eventually, the bubble burst, and the tech-heavy Nasdaq Composite index plummeted by 77% from its peak.
Data center spending looks unsustainable
Today, generative AI is filling the same role the internet played 20 years ago. And while the technology promises to be transformational, there are signs that the current level of investment is getting ahead of itself.
Wall Street expects hyperscalers to pour an eye-popping $700 billion into AI-related capital expenditures this year, and that number is expected to rise. The problem is that spending is beginning to exceed their operating cash flow, forcing them to look to external financing sources, like the debt market. This will make the stocks riskier because debt has to be repaid — regardless of whether the capital investments it funded actually pay off.
