Overview
Capital Economics is cautioning that the S&P 500's valuation metrics point to a potentially late and exuberant phase of the market's recent climb tied to artificial intelligence. In a Tuesday note, the firm's chief economic adviser highlighted the cyclically adjusted price-to-earnings ratio - the CAPE - as having risen sharply since the start of 2023 and now sitting above 40.
The CAPE's increase - more than 12 points from early 2023 - places the index's valuation at a level "last seen before the dotcom bubble burst," the note states.
How valuations are contributing
Capital Economics calculates that the CAPE has accounted for just over two-thirds of the S&P 500's rally that began in early 2023, which the firm broadly treats as the onset of the AI-driven advance. That dominant contribution from cyclically adjusted valuations informs the firm's view that the market may be entering a 'blow-off' phase of the rally - language the note uses directly.
At the same time, the advisory cautions that alternative, shorter-term valuation metrics present a less stark picture. The forward 12-month price-to-earnings ratio has climbed by fewer than four points and is currently near 21, which remains below its dotcom-era peak above 24. Likewise, the forward three-year P/E has added only about 13% to the rally and sits near 17, compared with a dotcom peak above 22.
Why Capital Economics places weight on the CAPE
The firm explains that it tends to give more emphasis to the CAPE for several reasons. First, there is skepticism about whether the recent exceptional growth in earnings per share is sustainable. Second, capital spending on technology is elevated relative to GDP. Third, the ratio of equity market value to net worth within the U.S. nonfinancial corporate sector is close to record levels. These three factors underpin the firm's preference for the longer-run CAPE measure when assessing valuation risk.
Implications for long-run returns
The note also points to the excess CAPE yield - a historical measure used to anticipate equity returns relative to Treasuries. According to Capital Economics, excess CAPE yield has been a reliable gauge of long-run equity performance versus government bonds in the past, and the present reading indicates below-average excess returns are likely over the coming decade.
Context and limitations
This analysis focuses on valuation measures and their historical relationships with market returns. The note contrasts longer-run CAPE dynamics with shorter-horizon forward P/E ratios, but does not offer forecasts beyond the statement that current CAPE readings point toward below-average excess returns versus Treasuries over the next ten years. The firm also labels the current pattern as one sign that the recent AI-driven rally may be in a late-stage ‘blow-off’ phase.
Bottom line
Capital Economics highlights stretched long-run valuations for the S&P 500, driven largely by a sharp rise in the CAPE since early 2023. While shorter-term valuation metrics are less elevated, the firm cites three specific concerns - sustainability of EPS growth, elevated tech capex relative to GDP, and a near-record corporate equity-to-net-worth ratio - and notes these support a cautious interpretation of current market pricing and prospects for long-run excess returns.