Bubble needle
iStockphoto/Petrovich9

Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about whether the U.S. equity market is in a bubble with Jack Manley, executive director, global market strategist with J.P. Morgan Asset Management. We talked about how investors may need to rebalance, and we started by asking where he sees concerns.

Jack Manley (JM): I think there are a lot of pretty sobering statistics that give a lot of investors pause when it comes to allocating new assets. One of the biggest problems is that there is a serious concentration risk within the S&P 500. Really, only a very small handful of names have done the bulk of the heavy lifting from a price-return perspective. And that’s the Magnificent Seven. The S&P 500 was up 24% in price terms in 2023. The Magnificent Seven accounted for a little over 60% of that. [In] 2024, the market’s up 23%. The Magnificent Seven accounts for 55% of that. This year, market’s up about 13% year to date. The Mag Seven accounting for almost 50% of that. So concentration risk is one of the metrics that you can look at when it comes to assessing whether or not this market is a little bubbly.

Another thing that you can point to is multiple expansion. Valuations have just continued to climb. The forward price-to-earnings ratio on the S&P 500 right now close to 23 times. To put that into historical perspective, that is higher than it was during the Covid surge, and is as high as it was since peak dot-com bubble.

And then, finally, one of the more recent indicators that we’ve been paying attention to is looking at the value of all U.S. corporate equity as a percentage of nominal GDP. We’re looking at around 360%. This is an all-time high and way higher than it was back in 2000 during that dot-com bubble. So a lot of different signs out there that this equity market is in something of a bubble.

Reassuring factors

JM: One of the things that I think does give me a little bit of confidence is that the interest-rate environment today is fundamentally different than the interest-rate environment 30 or 40 years ago. And interest rates matter a lot for a couple of reasons. First, they function as sort of the bogey, so to speak, for investors. When interest rates are at zero, basically anything in the equity market looks attractive. When interest rates are at 10%, well, now that hurdle is a whole lot higher. As interest rates get higher on the margin, the relative attractiveness of equities decreases. And as a result, multiples will typically compress.

The other thing that I would point to is that the composition of the equity market has shifted a lot over the last 30 or 40 years. The U.S. equity market used to be dominated by, you know, energy companies, by banks. These companies inherently command lower valuations. The market today is driven by technology. And technology inherently commands higher valuations, because it takes a longer time horizon. You’re buying these names, because you think in the next five, 10, 15 years, they’re going to totally transform the world. That does not mean that 23 times forward earnings is good. But if you think about that benchmark being re-based higher — maybe it should be 19 times, maybe it should be 20 — all of a sudden, you are looking at a market that is expensive but perhaps not as unreasonably so.

Another thing that I lean on to not worry so much about bubbly valuations, is that while the forward price-to-earnings ratio on the S&P 500 today is about as high as it was back during the dot-com era, there aren’t a lot more similarities beyond that between these two markets. During the dot-com era, these companies commanded extraordinarily high prices, but did not necessarily have the earnings to back those prices up. If you look at where we are today, that disconnect has narrowed quite a bit. These big companies really do pull their own weight in a way that was not necessarily true during dot-com. They have multinational footprints. They have proven track records of growth and of innovation. And in many cases, they have rock-solid balance sheets. So I don’t want to downplay the risk of a bubble. But where we are right now is a little bit higher quality, I would say.

And finally, what’s the bottom line on investing in the current moment?

JM: As investors think about rebalancing, the one big thing I would probably do is — within the S&P 500, at least — look to diversify, not out of the Magnificent Seven, but inclusive of the Magnificent Seven. Analysts are starting to get a little bit more optimistic about the prospect of the S&P 493. I think it makes sense to assess that broader index. It is harder to be excited about the U.S. equity market right now than it’s been in a while. But that doesn’t mean you can’t be constructive if you are a long-term, well-diversified, actively allocated investor. Volatility and pullbacks are a normal part of what it means to be an investor. But if you are disciplined and well diversified, there’s a pretty good chance that your long-term financial well-being will not be disturbed.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Jack Manley of J.P. Morgan Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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