Is the US stock market in bubble territory?

The writer is co-founder and co-chair of Oaktree Capital Management and author of “Mastering the Market Cycle: Getting the Odds on Your Side”

Many investors these days are on heightened alert for asset price bubbles, concerned about a repeat of past booms and busts.

Thus, I’m often asked whether there’s a bubble surrounding the handful of stocks that have been leading the S&P 500 stock index, the so-called “Magnificent Seven” technology companies which have dominated the index in recent years and been responsible for a highly disproportionate share of its gains. 

You can look at valuation parameters to discern a bubble but I’ve long believed a psychological diagnosis is more effective. I look for highly irrational exuberance — the outright adoration of a group of companies or assets resulting in a massive fear of being left behind if one fails to participate in the bubble on the conviction that, for these stocks, “there’s no price too high”. In particular, when I hear the latter, I consider it a sure sign that a bubble is brewing. In short, bubbles are marked by bubble thinking.

If bubble thinking is irrational, what is it that permits investors to get away from rational thinking? There’s a simple answer: newness. This phenomenon relies on another time-honoured investment phrase, “this time is different”. Bubbles are invariably associated with new developments, from the 1630s craze in Holland over recently introduced tulips, to the internet and telecoms stocks in the late 1990s. Since there is no historical indicator of what an appropriate valuation for the new thing might be, there’s thus nothing to tether it to terra firma. 

The bubbles I’ve lived through have all involved innovations, many of which were either overestimated or not fully understood. The attractions of a new product or way of doing business are usually obvious, but the potholes and pitfalls are often hidden. A new company may completely outclass its predecessors, but investors often fail to grasp that even a bright newcomer can be supplanted. The disrupters can be disrupted, whether by skilful competitors or even newer technologies.

In the 1990s, investors were sure “the internet will change the world”. It certainly looked that way, and that assumption prompted tremendous demand for everything internet-related. Ecommerce stocks went public at seemingly high prices and then tripled on the first day. There’s usually a grain of truth underlying every mania and bubble. It just gets taken too far. The internet absolutely did change the world, but the vast majority of dotcom companies that soared in the late 1990s bubble ended up worthless. 

Too much optimism on the new thing leads to pricing errors. Since bubble participants can’t imagine there being any downside, they often award valuations that assume success. In reality only a few newcomers may thrive, or even survive.

Stocks sell at multiples of the coming year’s earnings, reflecting the expectation that they’ll go on making money for many years. When you buy a stock, you buy a share of the company’s earnings every year into the future. When buying a stock at an above average price to earnings multiple, investors are paying for companies’ profits — even after giving them credit for significant growth — for many decades into the future.

Today’s S&P 500-leading companies are, in many ways, much better than the best companies of the past. They enjoy massive technological advantages and vast scale. But persistence isn’t easily achieved, especially in high-tech fields that are vulnerable to disruption. In bubbles, investors treat the leading companies as though they’re sure to maintain their leads for decades. Some do and some don’t, but change seems to be the rule more than persistence. 

Is the US stock market too high? It’s extremely rare for the S&P 500 to return 20 per cent or more for two years in a row. It happened in the past two years, with the S&P 500 up 24.2 per cent in 2023 and 23.3 per cent in 2024, bringing us to 2025. What lies ahead?

The cautionary signs today include the optimism that has prevailed in the markets since late 2022, the enthusiasm that is being applied to the new thing of AI, and the widespread presumption that the top seven companies will continue to be successful. On the other hand, the forward p/e ratio on the S&P 500 is high but not insane at 23.6 times. I also don’t hear people saying, “there’s no price too high” and the markets, while high-priced and perhaps frothy, don’t seem nutty to me.