Stock values climb near dot-com levels, but investors are less fearful of burst

One measure of the S&P 500's value is approaching the same level as the late 1990s dot-com boom, but investors appear less worried than they were earlier this year about a potential bubble bursting.

The discrepancy between near-historic valuations and declining fears of an impending downturn highlights what some analysts say is growing investor complacency, driven by beliefs that economic growth, strong corporate earnings and the Federal Reserve's loose monetary policy will continue to support the ongoing market rally despite growing fears of a sizeable correction.

"My belief is that those positive catalysts are priced in, and investors will be facing decelerating growth in each category," said Michael O'Rourke, chief market strategist with JonesTrading, in an interview.

Since January, the cyclically adjusted price-to-earnings, or CAPE, ratio for the S&P 500 has risen more than 11% and is now less than 15% from its height during the dot-com boom. The ratio is used to determine whether stocks are undervalued or overvalued. It is calculated by dividing stock prices by trailing 10-year average earnings, as opposed to the standard price-to-earnings ratio, which divides stock prices by analysts' earnings forecasts.

Meanwhile, credit investors' concerns about a potential asset bubble are abating, according to the latest Bank of America Securities survey, released July 16. Investors say they are more worried about rising rates and inflation than a bubble. Of investors surveyed, 41% said they are fearful of a bubble, down from 48% in January.

Phil Toews, CEO of Toews Asset Management, said most investors may be overlooking the potential risk of a bubble forming in the stock market simply because indexes continue to settle at record highs.

"[R]emember that markets lead sentiment, not the other way around," Toews said. "As long as they're positive and moving higher, investors aren't likely to turn cautious."

The CAPE ratio has a history of rising ahead of market crashes. The current ratio is roughly 15% higher than it was in September 1929, just a month before the massive sell-off that led to the Great Depression.

"It does raise some red flags," said Edward Moya, senior market analyst with OANDA.

The S&P 500's daily forward price-to-earnings ratio is up about 55% from the market trough in March 2020 but remains below its June 2020 high.

Stock valuations are reaching concerning levels by any metric, according to a July 21 market commentary from GMO, a Boston-based asset management firm.

"Many individual companies are deserving of their current high multiples … Unfortunately, they're also all being priced that way, and for us, that is a bridge too far," GMO's asset allocation team wrote.

Stock valuations are being pushed up by several forces, said Lyn Alden, who runs an investment research service. These include lower effective corporate tax rates for U.S. companies, a decades-long decline in 10-year Treasury yield that pushed investors into higher-priced stock exposure, and an increase in foreign ownership of U.S. equities.

Alden said the CAPE ratio may be reaching its peak but a continued rise is also possible if corporate-friendly tax rates and low bond yields continue.

The ongoing climb in the CAPE ratio may be more of a signal of the early stages of an economic expansion, rather than a sign of a nearing bubble burst, said Jeff Schulze, an investment strategist at ClearBridge Investments.

The CAPE ratio only looks at past performance while markets are driven by future earnings potential, Schulze said. The ratio has become "a bit outdated," Schulze said, pointing out that economic cycles previously lasted five years or less, but now may continue for over a decade.

"Recent cycles have been 10-plus years so some readings in CAPE don't include a recessionary event," Schulze said.