S&P500 valuation reaches bubble-like levels

The S&P500 is at a bubble-like valuation, second only to the 2000 dot-com bubble, based on the Shiller PE ratio. High valuation is consistent with a positive sentiment, and the index is entering August trading with a strong performance. However, the article does not provide specific details on the market's performance or potential risks.

The S&P 500 is currently trading at a valuation that is second only to the peak of the 2000 dot-com bubble, according to the Shiller PE ratio [1]. This metric, which adjusts for inflation and averages earnings over 10 years, reached its second highest point in U.S. history. The only time it was higher was right before the dot-com crash.

The traditional PE ratio (price divided by earnings) also indicates that the S&P 500 is near its fourth highest point, even when considering wild spikes like the 2020 money-printing rally and the initial confusion after the 2008 crash. This suggests that stocks are expensive by most traditional measures.

Adding to the concern is the Buffett Indicator, which compares the total market cap to GDP. This indicator has been at eye-watering levels for years, further highlighting the potential for overvaluation [1].

Market sentiment is also exuberant, with multiple indicators pointing to euphoria. For instance, the Citi's Levkovich Index, which measures margin levels, option pricing, and short interest, hit 0.65 last week, the third highest level of euphoria behind the 2000 dot-com bubble and 2021 post-pandemic retail-led meme stock mania [2]. The Barclay's Equity Euphoria Indicator (EEI) also shows similar signs of euphoria, mirroring the peak of the 2000 dot-com bubble and the post-pandemic meme stock mania [2].

The tech sector, particularly tech mega-caps associated with the AI theme, is leading the bubble. The Information Technology ETF (XLK) is trading at a 2025 forward ratio of 33, and even consumer-oriented companies like Costco (COST), Walmart (WMT), and Starbucks (SBUX) are trading at high PE ratios, reflecting overpriced earnings [2]. The Consumer Staples ETF (XLP), typically seen as a defensive sector, is also trading at a PE ratio of 22, indicating that even staples are expensive.

Despite the high valuation and euphoric sentiment, the market has been ignoring potential risks. The Trump administration's tariffs have been gradually increasing, with the average total US tariff now between 15% and 20%, significantly higher than last year's virtually no tariffs. This shift towards protectionism is expected to boost inflation and slow growth, potentially leading to stagflation [2].

Market participants have been encouraged by a solid labor market and stable inflation, leading to the expectation that the economy would remain resilient and the Fed would cut interest rates. However, inflation is showing early signs of reaction to tariffs, and growth is slowing, suggesting that the economy may not be as resilient as initially thought [2].

As the economy slows, even tech mega-caps, which have been driving the AI capex, may not be immune to the slowdown in consumer spending. Over the next two quarters, inflation is likely to keep rising, while growth is likely to keep slowing, potentially leading to an inflationary recession. The first confirming sign of deteriorating data is likely to bust the bubble in the S&P 500 as the euphoria fizzles, potentially being replaced with panic.

References:
[1] https://medium.com/wall-street-gradient/this-is-historys-biggest-bubble-6a27a660ed67
[2] https://seekingalpha.com/article/4807539-s-and-p500-euphoria-and-bubble-face-the-new-world-reality