The stock market has experienced a remarkable surge in recent years, with the S&P 500 index rising by about 57% in just the past two years and more than doubling over the past five. This growth has had a significant impact on investors, especially those with retirement savings in index funds, allowing some to achieve their financial goals earlier than anticipated. However, this rapid increase raises questions about the sustainability of such growth and concerns about potential future market corrections.
To understand the stock market, it’s important to grasp the fundamentals of stock ownership. A stock represents a share in a business, similar to owning a rental property. The rent (earnings) collected minus expenses results in profit, and the sale price of the property or stock should reflect the future expected earnings, determining the price-to-earnings (P/E) ratio.
If you had invested $100,000 in the market in 2019 and reinvested the dividends, that investment would now be worth $256,960, a 157% gain. Meanwhile, the earnings from this investment have only increased by 42%. As a result, the market’s P/E ratio has climbed from about 20 to 30, indicating a higher current valuation relative to earnings.
Higher P/E ratios generally suggest lower return expectations moving forward unless earnings rise significantly to justify the prices. Good news in the business world, such as the construction of a new campus or technological advancements, can justify paying more for future expected earnings.
Potential market corrections and growth sustainability
The current stock market euphoria is notably influenced by a handful of companies, the so-called “Magnificent Seven”: Apple, Nvidia, Microsoft, Amazon, Google, Facebook, and sometimes Tesla. These companies account for over 25% of the market’s total value and have P/E ratios significantly higher than the rest of the market. Excluding these companies, the remaining 493 in the S&P 500 have a more reasonable P/E ratio of 20.
One key driver behind the impressive performance of these tech giants is recent advances in Artificial Intelligence (AI). AI has made substantial leaps, enabling tasks such as detailed document analysis, driving cars, identifying medical conditions, and designing advanced medications. The hope is that AI will lead to unprecedented productivity gains, thus fueling further growth.
However, the future remains uncertain. While optimism abounds, challenges such as cost overruns, increasing competition, and potential societal implications due to AI advancements could impact these projections. The threat of AI-driven unemployment is another concern that could reshape the economic landscape.
Ultimately, while the past can offer some guidance, the future is inherently unpredictable. The US economy has shown steady growth of about 3% after inflation over decades, suggesting that despite significant changes, long-term growth remains a norm. Investors should remain mindful of the fundamentals and long-term trends, keeping a balanced perspective on both risks and opportunities as they navigate the financial landscape ahead.
