Traders work on the floor at the New York Stock Exchange in New York on Sept. 4.Brendan McDermid/Reuters
Is your portfolio looking great these days? So it should. Wall Street has just enjoyed its best nine-month performance to start a year since 1997.
It’s an achievement that is both exhilarating and ominous.
It’s exhilarating because U.S. stocks surged after October, 1997, and climbed nearly 50 per cent over the next three years. If history repeats itself – or even if it just rhymes – similar gains could happen again.
Yet, if history is any guide, the recent boom in stock prices could also be an ominous sign. The big gains of the late 1990s set the stage for a dramatic bursting of the dotcom bubble in 2000 and a long and painful decline in stock prices. By October, 2003, the S&P 500 Index of large U.S. stocks had slumped all the way back to where it sat in October, 1997, leaving many shareholders with nothing to show for six years of investing.
That, too, could happen again.
Historical analogies are always dicey, but the similarities between the past few months and 1997 are striking. In both cases, share prices soared to giddy heights, fuelled by a high-octane blend of technological euphoria and red-hot economic performance.
Consider the current situation. The United States economy defied expectations of a recession last year and is now growing at a more than respectable 2.5-per-cent-a-year clip. Inflation has faded, interest rates are tumbling and unemployment remains unusually low. The latest U.S. jobs report, published on Friday, burst past forecasters’ expectations and showed the economy added another 254,000 jobs in September. No matter how you slice it, that is a gob-smackingly good performance.
In fact, it’s almost as impressive as what prevailed back in 1997. Back then, the economy was booming ahead at a breakneck 3.9-per-cent clip, unemployment was unusually low and inflation was barely above 2 per cent.
Then, as now, people were betting big on technology. In 1997, the hot new development was called the internet. These days, it’s artificial intelligence, or AI.
It’s easy to see why investors are excited. Just as the internet transformed the global economy, so might AI.
However, the late 1990s demonstrate that buying into the latter stages of a tech boom can be a dangerous proposition for buy-and-hold investors.
The problem is price. In October, 1997, the S&P 500 was valued at extremely expensive levels – 32 times its average real earnings of the preceding 10 years, to be precise. These days, the situation is even more extreme, with the index valued at 37 times its long-run real earnings. Both values are double or more the historical average of 16 times.
Those lofty valuations should scream caution – or should they? What 1997 demonstrates is that frothy markets can go on getting even frothier.
At the moment, many observers see no reason to panic. Citigroup analysts, for instance, agree that the S&P 500 is fully valued by traditional valuation metrics, but argue it is not overvalued once you factor in falling interest rates and strong earnings growth. They see potential in growth stocks and energy stocks.
The market watchers at Capital Economics in London are even more optimistic because they are counting on AI euphoria to further inflate a stock-price bubble.
They pick U.S. stocks – and more specifically U.S. tech stocks – to lead the way over the next couple of years as renewed enthusiasm over AI drives markets higher. They see the S&P 500 rising from its current level around 5,700 to hit 7,000 by the end of 2025. They then predict the AI bubble will pop in 2026 and the index will tumble to 6,300 or so.
Maybe so. Risk-loving investors can bet on this volatile scenario unfolding according to plan. Others, though, may not feel quite so confident about their ability to get out in time.
The problem is not so much that anyone expects something horrible to happen but that it is difficult to see how things can get a lot better than they are now.
David Kelly, chief global strategist at J.P. Morgan Asset Management, noted this week that U.S. profits are running exceptionally high. From the 1940s to the 1990s, after-tax corporate profits in the U.S. typically amounted to somewhere between 5 and 8 per cent of gross domestic product. They have climbed steadily since then and now tick in at 10.9 per cent of GDP.
Can profits keep on climbing as a share of the economy? That seems rather hopeful. Much of the gains in after-tax earnings over the past couple of decades have been driven by falling interest rates, falling tax rates and falling union bargaining power. All those trends appear near their natural limits.
If profit growth is likely to flatten, market gains will have to depend on how much people are willing to pay for each dollar of earnings. As previously noted, though, investors are already paying unusually high multiples for stocks. Markets can always grow frothier in the short run, but counting on even more extreme valuations seems like a risky strategy.
Mr. Kelly suggests that right now is an excellent time for investors “to take some risk off the table by locking in gains rather than increasing risk by allowing a rising exposure to indices that have become more unbalanced and richly valued.” That seems eminently reasonable, even if you think this bull market has further to run.