Market Update – Fourth Quarter, 2025

ARE U.S. STOCKS IN A BUBBLE?  Media headlines are becoming increasingly littered with “bubble” talk.  Coincidentally, or not, Google search data show interest in the topic “stock market bubble” is on the rise over the last 12 months.

As U.S. stocks continue their march higher on the back of the AI frenzy, let’s look at some data as well as argue both sides of … bubble, or just a premium in the new AI world order?

IT’S A BUBBLE!

Valuation: Ok, relative valuation alone is not a timing tool; rather, it tells investors what multiple the market is comfortable paying for stocks, be it high or low. Everyone is frontrunning future “AI” earnings and cash flows.  It is impossible to even know if the return on investment will ever materialize to the levels needed to justify today’s price. We are clearly in nosebleed territory.  The Shiller/CAPE chart is one example. Currently, at 40x price-to-cyclically adjusted earnings, we are nearing the peak of the dot-com era when everyone thought that time was different too.

SOURCE: MULTPL.COM

Extreme concentration and narrow leadership: The Magnificent Seven (Microsoft, Nvidia, Alphabet, Apple, Amazon, Meta, and Tesla) plus Broadcom (AVGO) make up approximately 38% of the S&P 500 and accounted for nearly 80% of the S&P 500’s gain over the last 12 months. The below chart from Apollo gives off a “bubbly vibe” going back to 1995 showing the combined weight of stocks with at least 3% weight in the index.  Extreme concentration and narrow leadership create fragility.

SOURCE: APOLLO GLOBAL MANAGEMENT, SEPTEMBER 2025

Note there is another tailwind in pushing the biggest stocks even higher. It is the mechanical structure embedded in a stock market that is float-adjusted market-cap weighted.  This means the next incremental dollar invested into the S&P 500 must be allocated in proportion to the index constituents sized largest to smallest.  This creates a positive feedback loop, money flows into the S&P 500, disproportionately favoring the largest companies which also happen to be hugely successful and worthwhile of investment, so more money flows in … and the cycle repeats.  You can also see this dynamic by looking at the equal-weighted S&P 500 (RSP).  According to Bank of America, this is the widest gap on record between the S&P 500 and its equal-weighted version.

Disconnect between price and fundamentals: GDP growth for this year is estimated at 1.8%, down from 2.8% last year.  2026 estimates tick down to 1.7%. 

Earnings per share growth for the year should materialize around 8-10%.  2026 estimates for the S&P 500 EPS are currently at $304 per share, or just over 13% higher than this year. 

So, we have decelerating GDP and accelerating EPS growth on the back of all things “AI” even if it’s from another sector such as Utilities, because of course we need power for the computer overlords to consume.  The point here is valuation expansion, not fundamentals, explains about 70% of the index gains this year.

IT’S NOT A BUBBLE!

Valuation: Let us revisit the Shiller/CAPE chart.  This version of the price-to-earnings ratio is calculated using the average inflation-adjusted earnings from the previous 10 years. DataTrek highlights a couple points.  The 10-year earnings per share is $167, which gets us to the 40x and a chart that looks very stretched.  But what if we look at the last 5 years instead to account for the exceptional shift in earnings power of the largest and most impactful companies in the index?  In that analysis, the 5-year average is $232 per share, which puts the CAPE ratio at 29x, or in technical terms, “not so bubbly.”

SOURCE: MULTPL.COM & AIMA, INC

Cash flows support the CapEx, buybacks and return of capital to shareholders: We’ll spare readers from a cash flow statement analysis and instead quote Nick Colas and Jessica Rabe of DataTrek from their post on X earlier this month:

Using a run rate based on last year’s results, Microsoft generates net cash flows equal to Pfizer’s entire equity market value, buys a PayPal in CapEx, and returns capital equivalent to the value of a Delta Airlines annually.

Let that sink in for a minute. And it’s not just Microsoft. Including other hyperscalers and big tech companies they are generating more than $700 billion annually in operating cash flow! Why wouldn’t they pursue investment in the new AI frontier when they can fund it with cash from operations?

We’re in a new regime, a structural shift.  For all the concentration talk, it’s well deserved.  The top 10 of the S&P 500 are responsible for ~45% of the earnings.  That compares to ~20-25% in 2000.

Return on invested capital (ROIC) is roughly 25% for the top 8 companies, the highest in modern history.  It was ~12% at the 1999 peak.

Balance sheets of the leaders are extremely solid.  Leverage isn’t a problem and CapEx is building infrastructure, not vaporware.  We have entered a winner-take all digital economy.

SO, WHICH IS IT?

Well, two things can be true at the same time. On one hand we have extreme valuation, concentration, and narrow leadership in a moderating economy which is driving a disconnect between price and fundamentals.  Odds are history will smile at certain pockets of this market and say I told you so.

On the other hand, we have a real technological and structural shift taking place.  Regardless of the debate about future profitability, there is real revenue, cash flow and earnings to prove it is happening now. 

The challenge is the truth about tomorrow is unknowable today and the market will not sit around and wait to see precisely what the outcomes will be.  Sure, that’s part speculation but also forecasting and there is a difference.

Speculation carries a greater degree of assumption, conjecture and informed guess compared to forecasting, which models a range of outcomes based on data.  The quality and accuracy of that data is the keystone.

Bubbles tell us as much about mass market psychology and herd behavior of investors as they do about how right or wrong forecasts or speculators end up being. Having a process is vital to staying on track towards financial and investing goals.  Focusing on allocation and exposure management, diversification of outcomes and risk management will help investors navigate highly valued markets more than trying to decide what is and is not a “bubble”.

To our clients, thank you for the opportunity to serve your investment needs and please do not hesitate to contact us if you experience any material changes in your personal situation or would like to discuss any specific matters.

To our other readers, if you would like a complimentary review of your investment accounts or any other financial planning matters, please do not hesitate to contact us.  As fiduciaries, we will happily provide you with an unbiased opinion based on your specific situation.