In the autumn of 1929, Irving Fisher, one of the greatest American economists, stated: “Stock prices have reached what looks like a permanently high plateau.” This turned out to be one of the most incorrect forecasts ever made: in short order, US and global stock markets were hit by the Great Crash, which was followed by the Great Depression.
Some scholars argue that Fisher was analytically right: markets were indeed valuing the US capital stock correctly in 1929. But his “permanently” proved unambiguously mistaken. Maybe markets were in some sense “right” before the crash and wrong after it. But who cared? For investors and the hundreds of millions of people across the world whose lives were upended by the disaster, the gods of the stock market had failed for a generation.
Why might this story be relevant today? The answer is that the valuation of US stocks is even higher today than in September 1929. In only one other period since 1881 has there been a higher valuation of the US market than today’s. That was in 1999-2000, immediately before the bursting of the “dotcom” bubble. (See charts.)
We know what followed that peak: a fall in valuations that was as steep, though not as deep, as the one after 1929. The first global financial crisis after the disaster of the 1930s followed a little over six years after the bursting of the 1999 bubble, in 2007-09. This was not just a coincidence: the easy monetary — and relaxed regulatory — policies adopted after the stock market bubble burst contributed to the financial crisis.
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How can one best judge the valuation of stocks? The best-known metric is the cyclically adjusted price/earnings ratio developed by Robert Shiller, the Nobel laureate and Yale economist. Cape is defined as today’s value of the stock market divided by the average of the previous 10 years of earnings per share, both in real terms. Shiller also provides a “total return Cape”, which adjusts for changes over time in the payout policies of companies. There is a difference between the two calculations, but it is not large.
The intuition underlying this measure is simple: if people are paying more than has been historically normal for the underlying earnings of companies, the stock market can be judged to be relatively highly valued, and vice versa. Data for the US market, measured in the S&P 500, goes back to 1881. Over that period, the mean Cape has been 17.8, which indicates a healthy average real return of 5.6 per cent. There have also been three huge peaks: September 1929, at 32.6, December 1999, at 44.2 and, crucially, July 2026, at 41.4.
The Cape is a simple and effective measure of value. But Shiller also offers a more sophisticated one: “the excess Cape yield”. This measures the difference between the inverted Cape ratio — or cyclically adjusted aggregate earnings per share — and inflation-adjusted yields on Treasury bonds.
When stocks are expensive, the excess yield is low. When stocks are cheap, the excess yield is high. Crucially, when the excess yield is low, the subsequent 10-year excess returns on stocks have normally been poor. The excess yield is a mere 1.4 per cent in July 2026, far below its long-run average of 4.7 per cent. With stocks this expensive, the chances of healthy future returns must, again, be relatively low.
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How does today’s US situation compare with those of comparable markets elsewhere? One way of addressing this question is to examine the ratio of the total value of the stock market to GDP, also known as the “Buffett indicator” (after Warren Buffett). At over 200 per cent in the US in early 2026, this was extraordinarily high by US historical standards and more than double UK levels.
High valuations of US shares add to the size and relative dynamism of the overall US economy and so of its corporate sector to make its stock market far and away the world’s most important: in June 2026, it accounted for 55 per cent of the global value of stock markets (at current prices). The US market is a titan.
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Historically, when US valuations have come close to this sort of level, a crash has followed. Stocks almost always fall much more quickly than they rise. Will things be different this time?
We do know that the Cape is far from a perfect predictor of an imminent crash: if it were, it would not be; well-informed investors would then not allow markets to reach extreme positions in the first place and so crashes would be far less likely.
This time, boosters always say, is different. One justification for such optimism is the scale of the AI-related boom. Its impact includes expectations of huge profits for the “hyperscalers” (Amazon, Google, Meta, Microsoft and SpaceX) and also the suppliers of microprocessors (notably Nvidia) and memory chips. Although not yet floated, OpenAI and Anthropic are also expected to be highly rewarding, even at eye-popping valuations.
As the most recent annual economic report of the Bank for International Settlements notes, these buoyant expectations are fuelling an enormous surge in US investment, which itself raises economic optimism.
The view that artificial intelligence is a transformative technology is quite reasonable. But the history of investment surges underpinned by profound innovations does not show that the latter guarantee huge profits.
Over-investment, destructive competition, waves of bankruptcies and then painful consolidation are standard features of such episodes, from the railway booms of the 19th century to the internet boom of the 1990s. This is the classic capitalist story of booms and busts.
This matters very much for the future of today’s markets. As Chris Watling, chief executive at Longview Economics, noted in June, “a handful of AI-linked stocks accounts for roughly 40 per cent of the S&P 500’s market capitalisation, according to Bank of America data”. Thus, the current extraordinary valuations of the market depend on the continuation of the AI boom.
Given the scale of what is happening, the latter, in turn, depends on the materialisation of one (or both) of two hoped-for outcomes — faster productivity growth and/or a big shift in income from labour to capital. Neither is guaranteed. But if the former happened, real interest rates would rise, lowering the present value of the higher future earnings. If the latter happened, it would tend to create political and social upheaval — hardly the ideal environment for peaceful enjoyment of enhanced earnings.
Without such huge transformations in economic growth and the distribution of income, today’s Cape suggests prospective real returns of a mere 2.4 per cent, less than half the historic average. At some point people will realise this, and the market will crash.
One argument against such a pessimistic conclusion is that the US market has been more expensive on average since, say, 1960 than it was in the previous 80 years, perhaps because both economic management and access to index funds have improved. Thus, since 1960, Cape has averaged 21.7. This is indeed above the average of 17.8 since 1880. But that is still just about half of what it is today.
Current valuations look to be a huge stretch. Moreover, as Joachim Klement, a strategist at Panmure Liberum, wrote in the FT, not just the valuations but even the earnings themselves look to be in a bubble.
Nobody knows for certain what might trigger the corrections. But we can see plenty of opportunities for destabilising shocks in which a stock market plunge is just one part of a bigger story.
First, we have definitively lost the stabilising and benevolent US hegemon of old. Under today’s irrational and unpredictable management, anything is possible. The on-again-off-again war on Iran is the perfect example. The unpredictable trade war is another. Uncertainty has costs. Moreover, for the first time since its emergence as a superpower in the early 20th century, the US has, in China, a peer competitor.
Second, the ratio of public debt to GDP in the advanced economies is back to where it was at the end of the second world war, even though there has been no war, but a financial crisis, a pandemic and fiscal profligacy, notably that of Donald Trump, instead. According to the IMF, the US now has general government fiscal deficits of over 7 per cent of GDP. The public debt of emerging economies, though lower than that of advanced economies, is also at an all-time high.
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Private debt is also worrying. Data from the Institute of International Finance shows private gross indebtedness is close to where it was on the eve of the global financial crisis. Worse, there is procyclical financial deregulation, which is precisely what tends to occur some decades after the crisis that justified the earlier tightening. This inevitably exacerbates the perils of periods of “irrational exuberance” such as today’s.
Third, high and rising debt generates financial fragility. The BIS report focuses rightly on the interaction of the rising government debt with the increasing role of hedge funds in funding that debt. The strategy of the latter depends on leverage. That increases the risks of a panic in which trades unwind at high speed. We have already seen such disruptions early in the pandemic and again in the UK’s “Truss shock” of September 2022.
Yet this is far from the only form of financial fragility. Another is the lack of transparency created by the growing role of non-bank financial intermediation, especially in the US. Another, again, is the rapid pace of financial innovation, notably the rising role of weakly regulated stablecoins. Would these be as reliable as money needs to be in a crisis? If not, flight could heap panic on panic.
Fourth, the underpinnings of dynamic market economies — the rule of law, support for science, orderly government — are under attack, notably in the US. This links with the disarray of global economic governance, notably the trading system on which our economies continue to depend.
Finally, as Manoj Pradhan and Charles Goodhart argue in The Unanchored Central Banker, the combination of de-globalisation with ageing will, in the longer term, generate still higher interest rates and rising fiscal pressures. As a result, they argue that central banks will lose their ability to “anchor” inflationary expectations.
My best guess on what might trigger the correction? Fiscal pressures, higher long-term interest rates, forced monetisation, inflation, financial shocks and panics. But war and accelerated de-globalisation are also possibilities.
The markets, above all US markets, are not only ignoring all such threats, but also embracing a highly optimistic view of the prospects even of what is going well. Stocks are, as a result, extremely expensive.
So, what are investors to do? This depends, as always, on both their time horizons and capacity for bearing losses. If the former are long and the latter are large, they can stay fully invested. Those without the luxury of time or robust financial security need to hedge. Options are a possibility; cash (and not just dollars) and precious metals are others. In today’s world, remember the downside risks.
