The stock market has experienced a remarkable surge over the past several years. The S&P 500 index, a standard measure of its performance, has seen a 57% increase in the last two years alone and has more than doubled in the past five years. This rapid growth has left many investors contemplating their financial futures.
For some, the boom has accelerated their journey to retirement, while others are considering indulgent purchases or extravagant investments. One concerned reader asked recently, “The market seems to be in a huge bubble right now due to all sorts of hype around Artificial Intelligence. Does this make it more vulnerable to a huge crash in the future, and will it affect my retirement?”
To address this, we need to explore the stock market’s fundamentals, particularly price-to-earnings (P/E) ratios.
A stock, in essence, is a business asset similar to a rental property. When purchasing a rental property, your income is derived from the rent minus expenses. Similarly, in the stock market, your return is based on the earnings of the companies in which you invest.
If you had invested $100,000 in the stock market in 2019, your portfolio would be worth approximately $256,960 today—a 157% gain. However, the actual earnings from that investment have only increased by 42%, indicating that stock prices have outpaced earnings growth significantly. The P/E ratio has risen from about 20 in 2019 to 30 today.
So, is this surge sustainable, or are we heading towards a market correction?
AI hype influencing market volatility
The answer may lie in the current excitement around Artificial Intelligence (AI).
Advances in AI technology have led to increased investment in tech companies, particularly notable giants such as Apple, Nvidia, Microsoft, Amazon, Google, Facebook, and Tesla, collectively known as the “Magnificent Seven.
These seven companies contribute substantially to the S&P 500’s recent growth and have significantly higher P/E ratios than the rest of the market. Excluding these companies, the market’s P/E ratio appears more reasonable at around 20. The AI boom has created optimism across various industries.
Companies are building AI infrastructures, leading to substantial investments in technology. This has increased the market valuations of tech stocks, underpinned by expectations of future earnings growth driven by AI advancements. AI is poised to revolutionize numerous fields, from healthcare to software development, potentially creating a more productive and profitable economy.
However, the future remains uncertain. While AI holds promising potential, risks such as cost overruns, increased competition, and potential societal impacts like unemployment due to automation exist. These factors could temper the optimism surrounding AI and affect future market performance.
Ultimately, the market’s future is unpredictable. Historically, the U.S. economy has grown steadily by about 3% after inflation, providing a potential guide to future expectations. However, whether the current enthusiasm will translate into sustained economic growth remains to be seen.
Investors should stay informed and consider both the potential and the risks in the evolving financial landscape.
