Stock markets are hitting record highs and artificial intelligence companies keep going up. This makes some people wonder “are we in a bubble?” This question is about how people feel as much as it is about market facts. It’s normal to worry about bubbles, but thinking about them too much can hurt your investment returns. You might focus on trying to time the market instead of working toward your long-term money goals.
People often talk about market “bubbles” like everyone knows what they mean, but they’re actually hard to explain. Markets naturally go up and down in cycles. How you think about risk changes over time.
For every real bubble – like the late 1990s internet stock craze and the mid-2000s housing boom – there are many times when investor worries never came true. For example, after the 2008 financial crisis, investors kept worrying about new bubbles. But that time period became the longest rising market in history.
So asking “is there a bubble?” is different from asking “will the stock market go down?” We have learned from recent years that short-term market drops are normal and can happen without warning. Earlier this year, the S&P 500 fell 19% but came back in less than three months. Many people who tried to time the market during this period probably missed out when the market recovered.
While past results don’t promise future outcomes, the stock market has grown a lot over history despite occasional problems. In this uncertain time, how can you stay focused on building portfolios that match your financial plans?
Stock prices are high but there are important things to remember
To tell the difference between short-term drops and fears of a possible bubble, it’s important to think about value. Like everything in life, what matters in investing isn’t just the price you pay but what you get for your money. After all, investors buy stocks to own part of a business and its cash flows. Value measures like price-to-sales or price-to-earnings tell us not just the price of a share, but what we’re getting for that price.
The chart shows the Shiller price-to-earnings ratio. This gives us a view of long-term value trends by using inflation-adjusted earnings over the past ten years. The current level of 38x means investors are paying $38 for each dollar of past earnings today. This is well above the average of 27x. This number has changed over the past few years as markets have dealt with inflation, policy uncertainty, and ups and downs in technology stocks.
Many measures show that the stock market is expensive by historical standards. There are a few key points for investors to remember. First, valuations don’t reliably predict stock market returns in the short term. Instead, they tell us how much investors are willing to pay based on what they expect for the future. Even when stocks seem expensive, markets can keep rising for months or years if business basics stay strong. This is why trying to time the market often doesn’t work.
Second, while there are similarities to the 1990s tech boom since both times had high valuations and excitement about new technologies, there are some key differences. Unlike the unprofitable dot-com companies of the past, today’s market leaders are well established. They make good profits and have healthy balance sheets. Just as the information technology revolution helped all types of companies over the past few decades, artificial intelligence developments could do the same.
Third, not all bubbles “pop.” While valuations can come down if prices fall, they can also improve if earnings and other basics stay strong. Some of the excitement in today’s market is because people expect higher future earnings. Company performance has justified some of these expectations in recent quarters. Earnings growth has been stronger than many people expected.
Opportunities exist across different investment styles and company sizes
While valuations for the broad market are high, other areas are more attractive. The chart above shows that the price-to-earnings ratio for Large Cap Growth stocks is highest at 28x. Other stock market sizes and styles, including Large Value and Small Caps, have better valuations. They also continue to have healthy earnings growth.
This is also true across different stock market sectors. Artificial intelligence-related companies are mainly in the Information Technology, Communication Services, and Consumer Discretionary sectors. In recent quarters, positive trends have spread to other sectors with better valuations too. These include Financials, Industrials, and more.
For investors, including a range of sizes, styles, and sectors in a portfolio helps reduce “concentration risk.” This means not putting all your money in one type of investment. It can also improve the overall valuations of your holdings to better manage risk. It’s hard to predict exactly which areas of the market will do best at any given time. So holding an appropriate mix can help improve portfolio balance.
Time remains one of the most powerful investment tools
Perhaps the most important lesson from market history is that time tends to reward patient investors. This is true even for those who invest during periods of high valuations. The chart above shows that some of the biggest market events seem less dramatic when you look at them over years and decades. These are time periods that make sense for many investors’ financial goals. For instance, the tech and housing bubbles were challenging at the time. But both experienced recoveries as the market rose to new all-time highs.
This shows the importance of not only how you position your portfolio, but investment ideas that take advantage of longer time periods. One example is dollar cost averaging. This means investing the same amount regularly over time. Even people who invested at the worst points in history achieved positive returns over time. For example, those who invested at the 1929 market peak before the Great Depression still made money eventually. Starting during lower valuations generally produces better returns, but this advantage gets smaller over longer time periods.
Concerns about a “bubble” have grown as the market continues to reach new all-time highs. Technology stocks continue to grow in importance. Rather than focusing on what this means for the market in the short run, investors should consider historical lessons. They should think about how these lessons affect long-term portfolios.
The bottom line
Today’s market valuations are high due to strong earnings and business fundamentals. The key is keeping a diversified portfolio that can benefit from growth while managing risk.
