Many have observed that the Shiller PE Ratio indicator is is close to record highs, at 39 as of writing this, signifying that the stock market (specifically the S&P 500) is overvalued and possibly portending to a crash, as seen in 1999-2000 when the indicator crossed 40:
It’s worth to keep in mind that even if stocks are overvalued, that patiently waiting for a correction will not necessarily ensure a lower entry price; you may just end up waiting forever. For example, in 1995 stocks already appeared expensive according to the Shiller indicator, yet the crash didn’t come until five years later. By then, the S&P 500 never returned to its 1995 levels, so investors who sold for fear of the market being overvalued never got the chance to buy back in at a lower price.
But what if such inflated valuations are sustainable? PE ratios , interest rates , ‘animal spirits’, demographics and other common explanations or established metrics of valuations are insufficient for explaining why stocks have done so well or have seemingly detached from the ‘broader economy’,in what the WSJ calls the two-speed economy.
Yes, huge companies are generating massive profits that keep growing with each passing year, but it’s more that that. An overlooked explanation is that the uncertainty of business cycles, policy, and competition has largely been erased, particularly for the largest and most dominant of tech and retail companies, whereas decades ago there was less certainty of the macro landscape, and competition was a bigger threat.
Indeed, recessions have become much more infrequent and briefer, the most recent, in 2022, lasting a paltry 2 months:
20th-century valuation models assume frequent economic whipsaws, America having many hostile or close competitors (e.g. USSR, the axis powers, Great Britain), and complacency or suboptimality in regard to monetary or fiscal policy in response to macro shocks (e.g. the Smoot-Hawley Tariff Act).
By comparison, The Fed and Congress (aided by dollar reserve status), as seen in 2008 and 2020, are willing to pull out the stops to infuse liquidity and prop-up asset prices. Thus, keeping recessions brief, expansions prolonged, and recoveries ‘v-shaped’ as seen after 2008 and during Covid. Hence, much less uncertainty or fear of a repeat of the ’70s or ’30s, when policy was less reactive and less effective.
Consider a hypothetical: you could invest in a public company earning $50 billion annually under pre-2000s conditions, when competition was always looming. Alternatively, you could invest in the same company, but without that uncertainty. The second scenario would clearly justify a higher valuation, and therefore a higher P/E ratio. I think this is what is happening now.
Second, regarding competition, mega-sized tech companies can acquire competitors outright or create entire industries from the ground up by throwing unlimited funds, as seen with Meta, Google, and Microsoft’s forays into LLMs, becoming industry leaders at AI seemingly overnight even despite OpenAI having a 5-year head start. Chat GPT has not hurt Alphabet’s earnings, and Google has added AI features to keep up. 50 years since their founding, Apple and Microsoft are more dominant than ever. Same for Amazon, Meta/Facebook and Alphabet/Google 20-30 years later. The same for Walmart and Costco and other huge retailers. The notion that established players must fall to nimble competitors has clearly been obsoleted.
And third, more regulatory clarity. As mentioned before, the biggest of tech companies are immune to breakups compared to the 20th century, when this was a much bigger concern (e.g. United States v. Microsoft Corp. or the breakup of the Bell System). So combine all the above factors and you have a recipe for higher valuations.
The astute reader may try to draw similarities between Trump’s liberation day tariffs and the Smoot-Hawley Tariff Act, but this analogue does not really hold and shows the limitations of trying to use the past to predict the future. Those who assumed 2025 would be a repeat of the 1930s would have sold their stocks at the bottom; the market would go on to make new highs just months later. Trump has also shown a willingness to constantly change his mind and backtrack, like pausing or delaying the tariffs after the market dropped.
The blueprint today for mitigating recession or crisis is for central banks to slash interest rates and Congress to pass trillions of dollars of stimulus. This worked in 2008 and during Covid. The US had among the fastest recoveries in either crisis compared to the rest of the world by intervening so aggressively. This is also a further example of how policy has become better or more optimized, which can justify higher valuations.
By comparison, during the Great Depression, the fed actually raised interest rates to protect the dollar and gold, which backfired. The stock market was less important relative to the economy compared to today, so policy makers today now feel obligated to defend stocks and inflate asset prices, compared to the relative apathy of the ’30s or ’70s. Thus, conditions were so much different back then that it’s not that useful as a predictive model. Rather, it’s more instructive of what not to do.
A possible threat to this model is stagflation, like in the ’70s and briefly in 2022. This tends to make fiscal and monetary policy less effective, as the typical tools to inflate growth and the money supply presupposes deflationary conditions. Or, second, if the US somehow loses its standing in the world as a tech and economic leader, but I don’t see this happening. History is replete with examples of empires rising and falling, but America’s rivals today are either too weak or too indifferent to seriously challenge its hegemony.