And by lately, I mean the past several years or more.
The value of the S&P 500 index of stocks, where most of us hopefully have a good chunk of our retirement savings stashed into index funds, is up about fifty seven percent in just the past two years. And it has more than doubled in the past five.
This means that on a net worth basis, if you felt like you were only halfway to retirement as recently as the Covid Era, you may have suddenly blown right past the finish line. And some of us who were already retired long before that, may find ourselves eyeing up expensive properties or engaging in other money-burning-a-hole-in-our-pocket behaviors.
Is this real? Or is it all a bubble or some other sort of financial illusion?
As one reader recently asked me in an email:
“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 answer this question, let’s take a closer look at our current somewhat unprecedented financial world and stock market. And to understand that properly, it helps to go back to the roots of what a stock is:
A stock is a magical business arrangement which is really just a much more convenient version of a rental house.
When you own a rental house, you are entitled to collect rent. After you cover all the expenses related to the house, you get to keep the rest, and this amount is your profit.
If the average sale price of rental houses in your area goes up but the tenant keeps paying you the same amount forever, it may look good on paper but it doesn’t really mean anything unless you sell the house. And then you’d just have to turn around and pay that same higher amount for a different rental house.
Your paycheck remains unchanged unless you can make your little house rental business more profitable. So you might squeeze in a basement apartment, do some renovations, streamline expenses, or do other things to increase your net earnings.
When you eventually sell that house to another investor, the price they are willing to pay should be based on that future stream of income.
For example, if the house brings in $2000 per month ($24,000 each year) and the sale price is $240,000, the next investor is buying a business with a price-to-earnings ratio of 10, because 240k/24k=10.
But if you manage to convince someone to hand over $480,000 for that same house, you’ve sold at a P/E of 20. This is a much better deal for you as the seller, but quite obviously a less rosy future for the investor buying it.
Now back to the stock market. If you put $100,000 in the market in 2019 and reinvested the dividends, today you’d already have an astonishing $256,960 (a 157% gain on your original investment)
But in that same time period, your share of company earnings from that $100,000 basket of stocks has only gone from $5290 to $7540 (a measly 42% gain) – information you can get from handy analysis sites like multpl.com
In other words, the Price-to-earnings ratio has risen from about 20 back then, to about 30 today.
So as stock investors here in 2025, we’re just like rental house investors finding that house prices have more than doubled while rents are only up by a bit. Which makes the landlord business a lot less profitable, and we should expect exactly the same thing as stock investor: lower future profits as a percentage of our portfolio value.
That doesn’t mean it’s unprofitable to own either one of these things – stocks or rental houses. But it does mean that we should expect our future income from buying them at today’s higher price-to-earnings ratio should be lower than if we could get them on sale. It’s just basic math.
But Wait! What if the Earnings are Rising?
Let’s say you’re considering a rental house which is a bit overpriced based on today’s rent, but you happen to know that a big Apple campus is about to get built right nearby. At that point, you expect that rent will start climbing rapidly for many years to come. In this situation, you should be willing to pay more for those future earnings when you buy the house.
This is exactly why the price of an individual company’s stock will tend to rise when some good news comes out about the company. During the Covid era, people started buying more Peloton bikes so they could exercise at home, and investors (foolishly) believed this would be a permanent trend. So Peloton stock went way up. Later, reality sunk in that this was just a fad and Peloton sales returned back to normal levels, and so did the stock.
But what does it mean when the entire market goes up to much higher levels? Does it mean our entire economy is expected to grow much more quickly?
In the case of the current stock market euphoria, not exactly. Because if you dig into the share prices of the 500 big companies that make up our famous S&P 500 index, it turns out that almost all the recent growth – about three quarters of it – came from just the seven biggest companies, known as the Magnificent Seven: Apple, Nvidia, Microsoft, Amazon, Google, Facebook, and sometimes Tesla.
These are all high-flying, super profitable tech companies who have seen a lot of growth and hype recently, which has caused investors to get excited and bid up their share prices in hopes of even more future growth. Collectively, they make up over 25% of the entire market value ($17.66 trillion!) and have much more expensive P/E ratios than the rest of the market (a weighted average of about 45)
If you exclude these seven biggest companies and just consider the remaining 493, you will find a P/E of only 20, which is more reasonable although still much higher than average.
What this tells us is that while investors expect the overall US economy to be fairly healthy in the coming years, they expect the biggest tech companies to continue to enjoy much faster growth.
What Does This Have To Do With Artificial Intelligence?
There’s one common theme in the big tech company boom right now: recent advances in AI have surprised the business world as software is suddenly able to display human-like reasoning in a rapidly growing number of fields. And because of this, the entire business world is fired up into a frenzy.
Six of those Magnificent Seven companies are spending hundreds of billions of dollars to build preposterously large warehouses full of supercomputers, and the lucky seventh (NVidia) is on the receiving end of those billions since they make the supercomputers and the incredible demand allows them to charge insane prices while still shipping them out by the trainload.
But that’s just the first level of this boom, the AI Infrastructure. As you move down the chain, every other industry hopes we have entered a new era of productivity and thus profits will grow faster than ever.
They may actually be right: You can now do things like feed in an entire novel or legal document or piece of code and ask the AI to answer detailed questions about the characters, or identify loopholes in the contract, or even find and fix bugs for you. AI can also drive cars, identify melanoma from photographs of your skin, design medications thousands of times better than what we’re used to, and even bring humanoid robot bodies to life as mechanical workers.
The idea is that we’re on the verge of having an infinite workforce of highly intelligent AI employees who will work for us for free, eliminating the biggest constraint that humanity has had in the past: a finite supply of both intelligence and labor.
Having followed the field in some detail for a while, I personally think all this will come true, although the timeline is uncertain. And the people bidding the share prices up to these levels obviously believe it too.
But the question is, will the profits of these companies really come through at the levels they forecast? Or will there be surprises down the road: cost overruns, competition, or unexpected disasters as these newly smarter-than-us computers decide that they no longer want to be bossed around?
And what if we end up with massive unemployment and resulting social upheaval if this amazing technology puts us all out of work, leaving only Sam Altman atop his personal mountain of $100 trillion dollars taunting the world forevermore with an annoyingly quiet monotone cackle?
There’s Only One Real Answer: Nobody Really Knows!
While the future is unknown, it can still be useful to use the past as a guide. After all, if you look at the history of US economic growth over time, it averages out to a surprisingly steady figure, decade after decade: about 3% after inflation.
One thing I noticed when making this graph: recent decades have actually seen slower than average growth, which is even less reason for the stock market to be priced the way it is.
So What Does it all Mean? Should We Do Anything About It?
As I said earlier, it’s still going to be profitable to own stocks for the long run, just a bit less profitable than those times when we got to buy our stocks on sale. Of course, there will be occasional manias and panics and crashes. But as always, it will be a losing game to try to time them – for example by selling all your stocks now and hoping to buy them at a cheaper price at some point in the future.
And over the long run, even if stocks return to more typical valuations, the end result would be something like the yellow line in this graph:
Our economy will continue to grow and company earnings will grow along with it, but future investors might choose to pay a lower multiple for those earnings.
Just like when you eventually sell that rental house, you shouldn’t expect someone to pay you a million dollars for a place that only brings in $3000 of rent.
Final Thoughts And Alternative Strategies
Everything we’ve covered so far is talking about the entire US stock market as a whole. And that’s what I usually focus on most because I still think this country is a uniquely good place to run a business. But what about other investing options? It’s always fun to at least look around and understand the larger investing world.
For starters, there’s Vanguard itself, the bedrock of the index fund world. Every year they gaze out at the investing horizon and make a ten-year forecast (guess) at future returns. This year they came up with these numbers:
Vanguard’s updated 10-year annualized return projections:
- Global bonds, non-U.S.: 4.3% – 5.3%
- U.S. bonds: 4.3% – 5.3%
- Global equities (ex-U.S., developed): 7.3% – 9.3%
- Global equities (emerging): 5.2% – 7.2%
- U.S. equities: 2.8% – 4.8%
Wow look at that. Vanguard is forecasting that International stocks of all kinds and even bonds will outperform US stocks in the coming decade.
On the surface, this makes sense because the P/E ratio of the international stocks (for example the VXUS fund) is only 15.9, meaning those European stocks are on sale at almost 50% off compared to ours!
Just one note of caution however: Vanguard has been making this same prediction for several years and just been wrong so far. Part of the reason is that most of the AI boom seems to be happening in the US.
The Betterment Portfolio
Longtime readers know that I’ve had a growing portion of my investments in a Betterment (robo-advisor) account over the past eleven years (see the ongoing report here). I decided to try this for precisely the reasoning above: by allocating money across more categories than just US stocks and automatically rebalancing, we should be able to see slightly higher returns with slightly lower volatility, and some tax advantages as well.
So far, my experiment has drawn some heat because in retrospect, a US-only portfolio has outperformed any other option over this time period. The Betterment portfolio comes close, but the exposure to bonds and businesses in other countries has held it back, just as you’d expect. But if you believe that things will eventually balance out again in the coming decades as the Vanguard analysis suggests above, it still has a chance to catch up.
Looking at my investments there, you can review the betterment core portfolio and calculate that the weighted average of all those holdings gives us a P/E ratio of about 22.
What Does Warren Buffett Say?
It’s always worth checking in with The Oracle on matters of the economy while we’ve still got this wonderful old sage around (see this year’s Berkshire Hathaway Shareholder letter if you want some further deep reading). And Warren is signaling that things are overvalued and bargains are few and far between. So Berkshire is holding $334 billion of uninvested cash for now, not even repurchasing its own shares which it considers slightly overvalued at the current P/E ratio which averages out to about 21 in recent years.
What About Paying Off Your House?
Over the long run, you usually do better if you keep a mortgage on your house and pay it off slowly, while directing all the surplus cash into index funds. But there is some point at which the opposing factors of lower expected stock returns and higher interest rates meet in the middle and this situation flips.
If you have a 7% mortgage right now, it might be a fairly close tradeoff at this point. But the real factor is how you feel about paying off your house. I happen to love being mortgage-free so I paid off my last mortgage over ten years ago and have never looked back.
Another way to think of this is that paying off your house is like buying a 7% bond. Definitely one of the best guaranteed returns around, and much more sensible than leaving tens of thousands of dollars in a checking or savings account unless you have a clear use for that cash.
The Final Word
If you’ve read any of my stock investing articles before, you’ll know that we always end up at the same place: Just relax, enjoy your life, keep investing, ignore the daily news headlines* and don’t worry.
Then reinvest that time that everyone else spends worrying into enjoying more time engaged in hard physical stuff in the great outdoors. That’s the only place where you’ll get guaranteed market-beating returns, every time.
In the Comments: what are your thoughts on the current stock market boom, future crashes and busts, and the role of Artificial Intelligence in our future?
All the other MMM Stock Market Articles from past years:
- Finally, a Stock Market Crash!
- What to Do About This Scary Stock Market
- How About that Stock Market!?
- Houses and Stocks are Going Up – Who Cares?
- How to tell when the Stock Market is on Sale
- Summer Clearance Sale on US Stocks!
*although in my opinion it’s okay to check in weekly with The Economist, which has been my favorite source of world economic news for 32 years and counting.
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