The sharp rise in U.S. equity valuations may indicate that the artificial intelligence-fueled bull market is entering its most speculative phase, according to Capital Economics.

In a note published Tuesday, Chief Economic Adviser John Higgins highlighted that the S&P 500’s cyclically adjusted price-to-earnings ratio (CAPE) has climbed more than 12 points since the beginning of 2023 and now sits above 40.

According to Higgins, the measure has reached “a level last seen before the dotcom bubble burst.”

Capital Economics estimates that valuation expansion, rather than earnings growth alone, has been responsible for a significant portion of the S&P 500’s advance since early 2023, which the firm views as the starting point of the current AI-driven rally.

The CAPE ratio has accounted for more than two-thirds of the index’s gains over that period.

Higgins said this development is “one sign that we may be in the ‘blow-off’ phase of the AI-fuelled rally.”

While the CAPE ratio points to stretched valuations, other metrics appear less alarming.

The S&P 500’s forward 12-month price-to-earnings ratio has increased by fewer than four points since the start of the rally and currently stands at roughly 21.

That remains below the levels reached during the dotcom era, when the measure exceeded 24.

Similarly, the forward three-year earnings multiple has contributed only a modest portion of the market’s advance and currently sits near 17, compared with a peak above 22 during the technology bubble.

Despite the more moderate signals from traditional valuation measures, Capital Economics continues to place greater emphasis on the CAPE ratio.

The firm cited three key reasons for its caution: doubts about the durability of recent earnings-per-share growth, elevated technology-related capital expenditures relative to GDP, and a near-record ratio of stock market value to net worth among U.S. non-financial corporations.

These factors suggest that current valuations may be vulnerable if expectations for future growth begin to weaken.

Higgins also pointed to the excess CAPE yield, a metric that compares prospective equity returns with Treasury yields and has historically served as a useful guide for long-term market performance.

Based on current readings, the indicator suggests investors may face below-average excess returns from equities relative to government bonds over the coming decade.

While Capital Economics is not forecasting an imminent reversal, the firm believes the combination of elevated valuations and ambitious growth expectations warrants increased caution as the AI-driven market rally continues.

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