Why Today's Stock Market May Stay Overvalued Despite Bubble Risks

The stock market is currently experiencing record valuations relative to the underlying businesses, with some of the most valuable companies projected to take hundreds of years to repay investors. This situation is often justified by an optimistic outlook on the future, envisioning a "corporate utopia" driven by advanced AI, low interest rates, and increased consumer spending. However, this perspective assumes perfection, which seems increasingly unlikely given current global economic challenges.

Current Economic Headwinds

Several significant issues suggest a bumpy road ahead for the economy:

• Active Oil War: Geopolitical tensions are impacting oil reserves, which are dangerously low.
• Rising Inflation: Inflation is resurfacing, potentially necessitating further interest rate hikes.
• Debt Concerns: Ballooning national and consumer debt will be significantly affected by rising interest rates.
• Trade Uncertainty: Two years of trade uncertainty have created an unstable economic environment.
• Questionable Investments: Some of the largest historical investments are yielding questionable economic results.
• Systemic Financing Issues: Potential systemic problems exist within the financing vehicles holding the market together.
• Tariffs: New tariffs, such as the recent 50% tariff on Canada, add further economic strain.

These factors are expected to impact companies' top-line revenue, operating costs, and ongoing expenses, affecting their entire income statements. While assets like housing and gold have seen declines (housing down across broad areas, gold down 25% from its all-time high), the stock market continues to climb.

Comparing Today's Market to the Dot-Com Bubble

There's a temptation to compare the current market to the dot-com bubble of the late 1990s and early 2000s, both characterized by rallies fueled by speculation in new technology, infrastructure investment, and circular financial dealings, leading to companies with questionable fundamentals. However, this comparison might be unfair to the dot-com era.

During the dot-com bubble:

• The economy was in a much better position.
• Debt was lower across the board.
• The market was less concentrated.
• Geopolitical uncertainty was lower.
• Speculation was relatively tempered outside of the dot-com companies themselves.

Many have been predicting a major market correction since 2010, but these predictions have not materialized, making being early an expensive mistake. For example, fund manager John Hussman has forecasted a 40% or more collapse almost every year since 2013, during which time the market compounded at roughly 13% per year.

Why the Market Might Not Be Overdue for a Correction (Yet)

Several arguments explain why the market might continue its upward trend despite apparent irrationality:

Concentration Risk

The stock market today is significantly more concentrated than during the dot-com bubble.

• In 2000, the top 10 S&P 500 companies accounted for roughly 10% of its total market cap.
• Today, they account for 40%.

While this concentration represents a risk, it also means that a large portion of the market is tied to very large, established companies, as opposed to hundreds of new, pre-profit listings that dominated a larger share of the market in the late 1990s. These top companies are less likely to fail because they have real market presence and generate substantial profits. The top 10 S&P 500 companies generate around 30% of the index's actual operating profits, a stark contrast to the dot-com era. After the dot-com bust, market leaders lost value, but their overall share of market value increased as many smaller companies were acquired, delisted, or went bankrupt. The number of listed companies in America peaked at over 8,000 in the late 1990s, with roughly half disappearing over the next decade and a half.

Resilience of "Magnificent Seven" Companies

Even in a hypothetical worst-case scenario where AI completely flops, the "Magnificent Seven" companies (e.g., Apple, Microsoft, Amazon, Google, Nvidia, Tesla, Meta) would likely still make money. Only Nvidia has a significant portion of its business directly tied to selling AI technology itself (75% of its $81 billion revenue last quarter came from data center hardware). The other companies primarily generate revenue from ads, cloud subscriptions, iPhones, and enhanced cruise control. For most of these companies, AI is an expense. A total abandonment of AI could even improve their earnings by reducing spending on data center build-outs, high salaries, and infrastructure depreciation, allowing them to return to being cash flow monsters with significant stock buybacks.

Furthermore, most of these mega-cap companies are not historically overstretched in terms of valuation, even with significant AI expenses factored in. Some financial experts even consider these companies to be cheap.

Relative Value and Market Dynamics

While P/E ratios are stretched and earnings growth isn't keeping pace with prices, the market continues to climb. This raises the question of whether this is sustainable or if investors are simply choosing not to look too closely.

The "Magnificent Seven" companies, despite their high valuations, are often considered "cheap" relative to the rest of an expensive market. Historically, the biggest companies in the market trade at a significant price-to-earnings premium (50% to 100%) over others due to diversification, brand awareness, and market dominance. Today, the Mag 7 still trades at a higher P/E ratio than the other 493 companies in the S&P 500, but the premium has shrunk to about 10%, the thinnest in over a decade. Excluding Tesla, the gap is even smaller. This shrinkage is largely due to these companies making significantly more money; Mag 7 profits grew 63% in Q1 this year, compared to 17% for the other 493 companies.

Market Cap to GDP Ratio

The total value of American public companies is currently around 234% of GDP, surpassing the previous record set in 1999 during the dot-com bubble. Warren Buffett described a version of this ratio as "probably the best single measure of where valuations stand," suggesting the current market makes 1999 look responsible.

However, a counter-argument is that today's companies are global, with revenue and investors from across the planet. Local disruptions like tariffs or housing slumps have less impact than when American companies primarily sold to Americans.

Investor Behavior and Lack of Alternatives

The vast majority of these assets are owned by wealthy individuals who have more money than they need. The top 10% of American households own about 87% of all corporate equities and mutual fund shares, while the bottom half owns 1.1%. These wealthy holders often borrow against their portfolios to access liquidity rather than selling shares. Margin loans are at a record $1.42 trillion, and Morgan Stanley reports that 80% of their client households now borrow against their accounts, up from 14% five years ago.

For those who might consider selling, the alternatives are not compelling:

• Bonds: While bonds offer decent interest, trust in stable interest rates is low, with roughly half of the Fed's committee discussing further hikes.
• Housing: Housing has been falling in real terms for 11 straight months and outright in many cities.
• Gold: Gold, once considered a safe haven, has also seen declines.
• Bitcoin: Bitcoin is currently worth about half of its value from October last year.

The lack of better investment opportunities means wealthy investors have little incentive to sell, contributing to the market's sustained high valuations.

Money Supply and Market Valuation

The total US stock market is currently valued at around $74 trillion, while the M2 money supply (physical dollars, checking, and savings) is about $22.7 trillion. Asset prices have climbed significantly since the 2020 stimulus measures, with much of this money flowing into investments. The total value of the stock market crossed three times the amount of actual money in circulation last year and now sits at a ratio of 3.3. The only other time this ratio was close was during the run-up to the dot-com bubble.

Again, the argument is that these companies have outgrown their host economy, and compared to the global money supply, their value might still appear modest.

The Case of South Korea (KOSPI)

The KOSPI index in South Korea roughly doubled in six months, driven by two chip companies, Samsung and SK Hynix, which together make up about half of the index. These are real companies with global customers and profits. However, over three and a half weeks, their market still fell 25%, experiencing emergency trading halts and forced liquidations. While the market has since bounced back, this example demonstrates that even strong, concentrated markets are not infallible.

The market is not necessarily missing the signs of a potential bubble; rather, those with more "voting power" (i.e., significant capital) currently favor the arguments supporting continued growth. Understanding these arguments is crucial for navigating the current financial landscape.