Just how frothy is America’s stock market?

IT IS the most wonderful time of the year, and for investors in America’s stock market, that is saying something.

They have had a marvellous 2024, as share prices that had already soared in 2023 just kept on going. The S&P 500 index of large firms is now 54 per cent higher than it was two years ago, a winning streak it has bettered just a handful of times since its inception in 1957.

To be sure, there have been jitters along the way. The most recent came on Dec 18, when share prices fell by 3 per cent in a single day after the Federal Reserve predicted it would cut rates by less than the market expected in 2025.

Yet, share prices have recovered a little since and the mood is still upbeat. Stock markets elsewhere in the world have also raced higher; America’s has left them in the dust.

The most memorable period in which share prices have risen faster (though not by much) occurred during the late 1990s. Then, a frenzy for Internet and telecoms stocks was inflating the dotcom bubble.

Once again, today it is hopes that a new technology will deliver bumper profits – in this case, artificial intelligence (AI) – that have powered the boom. And so, one question has loomed large all year: Has the exuberance remained rational, or is this another bubble?

To measure the excitement, consider three different ways of gauging investors’ enthusiasm.

First, sentiment, or how optimistic they are about the potential for even more bumper returns. Survey data from the Conference Board, a research outfit, confirms the bullish impression given by the sheer speed with which prices have climbed.

Every month since 1987, it has asked American consumers whether they think share prices will rise over the following 12 months. In the latest survey, 56 per cent of respondents thought they would – an all-time high by some distance and well above the 26 per cent who answered similarly in 2022, shortly before the rally got going.

Another survey, carried out by the American Association of Individual Investors, also showed a strong (though not record-breaking) degree of optimism.

As retail investors bid stocks up, the professionals are betting that markets will remain calm, at least in the short term.

The VIX index, which measures how much traders pay to protect themselves against turbulent share prices over the coming month, fell to millpond-like levels before the Fed triggered Dec 18’s sell-off. Even after that, it still predicts lower-than-average volatility. The Move index, a similar metric for interest rates, has plummeted since America’s presidential election.

Such benign expectations might be proved correct. Alternatively, they might indicate that those who believe so have already traded accordingly, leaving fewer willing buyers and more potential for panic should the mood shift.

The outlook, in other words, depends on how heavily investors have already bet on the bull run continuing – the second gauge of their exuberance.

It seems they have bet very heavily indeed. Every month since 2001, Bank of America has asked fund managers who invest globally how “overweight” (relative to their benchmarks) their allocations to American stocks are. December’s survey yielded the most extreme result on record.

It is not just fund managers: Over the course of 2024, investors pumped around US$450 billion into funds that buy American shares, and US$30 billion into funds that invest only in small American firms. Both figures also broke records. Funds investing in cryptocurrencies, one of the frothiest asset classes of all, had their best-ever year for inflows, too.

The result of all this money flowing into stocks, at the same time as prices are rising, is that they now make up an unusually large chunk of investors’ portfolios.

Analysts at JPMorgan Chase, a bank, estimate that the aggregate equity allocation of the world’s non-bank investors stands at 49 per cent. That is only a shade below a previous peak reached in 2007, which itself was only surpassed during the dotcom bubble.

Investors’ cash allocation, meanwhile, is at an all-time low. Those looking for willing buyers with the cash to keep bidding prices up will need to hunt hard.

The third gauge of the market’s bubbliness – and an indicator of what might follow investors’ surging animal spirits – is valuations.

Possibly the most watched measure is the cyclically adjusted price-to-earnings (Cape) ratio, popularised by Robert Shiller of Yale University. This is the multiple by which average annual earnings over the past decade, adjusted for inflation, must be scaled up to reach share prices. A high Cape ratio means that investors are paying more per dollar of profit to own a stake in the company generating them.

Just now, the Cape ratio for America’s stock market is higher than it has been for 98 per cent of the time since 1900. Just before stocks sold off on Dec 18, it had only been higher during the dotcom bubble and, very briefly, in 2021.

Measured differently, by price-to-book ratio rather than price-to-earnings, shares are now even more expensive than at the previous peak in 2000.

Sky-high valuations do more than recall bad memories. They also indicate that future returns are likely to be poor. Corporate profits, after all, are the ultimate source of stock market returns. If profits are small compared with share prices, that suggests the yield from owning shares will be low.

This is encapsulated by the “Cape yield”, which is the inverse of the Cape ratio, and hence low when valuations are high. Historically, since 1900, the lower the Cape yield has been, the worse returns have been over the subsequent decade.

At present, the Cape yield for the S&P 500 is 2.6 per cent. From starting points where the yield was at this level or lower (which it has only been during the late 1990s and early 2000s), the index has never had a positive return over the following 10 years. When the Cape yield has been between 2 and 3 per cent, the average annualised return has been -1.5 per cent in nominal terms, and -4 per cent in real terms.

The valuations of adjacent markets, meanwhile, hardly offer comfort.

The average yield on America’s risky “high-yield” corporate bonds is 2.9 percentage points above the equivalent yield on government debt, the lowest such spread since 2007. For safer “investment-grade” debt, the gap is just 0.8 percentage points, the lowest since 1998. Both episodes were followed by soaring default rates.

Stock markets in other countries show just how extreme American valuations have become. The Cape ratio for European shares, for instance, is less than half that for American ones, and the gap between the two is at a multi-decade high. Europe is no outlier.

The firms in MSCI’s index of American shares now account for 70 per cent of the market value of those in the index for all developed markets, another multi-decade high. And even within America’s stock market, value has become astonishingly concentrated.

Together, its biggest 10 firms are now worth 40 per cent of the overall capitalisation of the S&P 500 index – up from less than 25 per cent five years ago, and the highest since at least 1980.

None of this proves that America’s stock market will crash in 2025. Donald Trump will shortly return to the White House, having promised tax cuts and deregulation that could send share prices even higher. AI might boost profits after all. And bubbles do not need to pop; they can also deflate gently.

Has one formed in 2024? It is getting hard to conclude otherwise.

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