In December 1996, Alan Greenspan used the words "irrational exuberance" to describe the stock market at the time, and those words not only became the title of Robert Shiller's cautionary book on market bubbles, but also the beginnings of the belief that central bankers had the wisdom to be market timers and the power to bend the economy to their views. I think that Greenspan's words seem prophetic, only with the benefit of hindsight, and I believe that central bankers have neither the power nor the tools to move the economy in significant ways. I was reminded of that episode when I read that Jerome Powell, the current Fed chair, had described the market as "fairly highly valued". In market strategy speak, these are words that are at war with each other, since markets can either be “fairly valued” or “highly valued”, but not both, but I don't blame Powell for being evasive. For much of this year, and especially since April, the question that market observers and investors have faced is whether stocks, especially in the United States, are pushing into “bubble” territory and headed for a correction. As someone who buys into the notion that market timing is the impossible dream, you may find it surprising that I think that Powell is right in his assessment that stocks are richly priced, but that said, I will try to explain why making the leap into concluding that stocks are in a bubble, and acting on that conclusion are much more difficult to do.
Financial Markets in 2025
It has, to put it mildly, been an interesting year for stocks, as economic headwinds and shocks have mounted, with tariffs, wars and politics all adding to the mix. After a first quarter, where it looked like financial markets would succumb to the pressure of bad news, stock markets have come roaring back, surprising market experts and economists. As a precursor to answering the question of whether stocks are "fairly highly valued" today, let’s take a look at how we got to where we are on September 30, 2025.
Resilient Equities
We will start with US equities, and while that may seem parochial, it is worth remembering that they represented more than 50% of the total market capitalization of all traded stocks in the world at the start of 2025. In the figure below, we look at the S&P 500 and the NASDAQ, with the former standing in as a rough proxy for large US market cap stocks and the latter for technology companies:
As you can see, US equities were down in the first quarter, but the standardized values indicate that it was much worse for technology companies than for the rest of the market, with the NASDAQ down 21.3% through April 8, the market bottom, while the S&P 500 was down 14.3%. On April 8, the consensus wisdom was that the long-awaited correction was upon us, and that tech stocks would take more of a beating over the rest of the year. The market, of course, decided to upend expectations, as tech came roaring back in the second and third quarters, carrying the market with it. In fact, through the first three quarters, the NASDAQ has reclaimed the lead, up 17.3% so far this year, whereas the S&P 500 is up 13.7%.
We take a closer and more detailed look at all publicly traded US equities, in the table below, where we break out the year-to-date performance, by sector:
The aggregate market capitalization of the Mag Seven, as a percent of market cap of all traded US companies, has risen from 17.5% at the end of 2022 to 24.6% at the end of 2023 to 29.3% at the end of 2024. Focusing just on 2025, the Mag Seven took a step back in the first quarter, dropping to 26.3% of overall market cap on March 31, 2025, but has made a decisive comeback since, with an increase in market cap of $2.8 trillion in the first nine months of 2025, accounting for 52.4% of the overall increase in market capitalization this year. In fact, the Mag Seven now command 30.35% of the total market capitalization for US equities, a higher percent than at the start of the year. Over the last three years, the Mag Seven alone have accounted for more than half of the increase in market capitalization of all US equities, each year.
There are other dimensions on which you can slice and dice US equities, and we did a quick run through some of them, by breaking US companies into groupings, based upon characteristics, and examining performance in each one:
- Small cap versus Large cap: For much of the large century, small cap stocks (especially those in the bottom decile of market capitalization) delivered higher returns than large cap stocks. As I argued in a post from a decade ago, the small cap premium has not just disappeared since the 1980s, but been replaced with a large cap premium. Looking at returns in 2025, broken down by market capitalization at the start of the year, here is what we see:As you can see, this has been a good year for small cap stocks, with the bottom half of the market seeing a much bigger increase, in percent terms, in market cap than the top half of the market, with much of the outperformance coming in the third quarter.
- Value versus growth: Another enduring finding from the last century is that low price to book stocks delivered higher returns, after adjusting for risk, than high price to book stocks. While this is often categorized as a value effect, it works only if you accept price to book as a proxy for value, but even that effect has largely been absent in this century. Breaking down stocks based upon price to book ratios at the start of 2025, here is what we get:While it is too early to celebrate the return of value, in 2025, low price to book stocks have done better than high price to book stocks, but all of the outperformance came in the first quarter of the year.
- Momentum: Momentum has been a stronger force in markets than either market cap or value, and unlike those two, momentum has not just maintained its edge, but strengthened it over the last few years. Using the price change in 2024 as a proxy for momentum, we broke companies down into deciles and looked at returns in 2025:After lagging in the first quarter, momentum stocks have made a comeback, with the top half of momentum stocks now leading the bottom half for the year to date in percent change in market capitalization.
Directionless Treasuries
While interest rates are always a driver of stock prices, they have played less of a role in driving equity markets in 2025 than in prior years. To see why, take a look at US treasury rates, across maturities, in 2025:
Rates have for the most part are close to where they were at the start of the year, with very little intra-year volatility notwithstanding economic stories about inflation and real growth suggesting bigger moves. The battle between the Trump administration and the Federal Reserve has received a great deal of press attention, but the Fed's inaction for much of the year and lowering of the Fed Funds rate in September seem to have had little or no impact on treasury rates.
On May 16, 2025, Moody's lowered the ratings for the United States from Aaa to Aa1, joining Fitch and S&P, but again the effect on treasury rates was transient. If you are wondering why this did not translate into an increase in default spreads (and rates), the likely answer is that markets were not surprised by the downgrade, and the best evidence for this is in the 5-year US sovereign CDS spread, a market-set number for default risk (spreads):
As you can see there was a spike in the US sovereign CDS spread this year, but it happened in response to liberation day on March 31, when President Trump announced punishing tariffs on the rest of the world. The Moody's downgrade had little impact on the spread, and even the tariff effect had fully faded by September 30, 2025, with spreads back to where they were at the start of the year (and for much of the last few years).
Extending the assessment of default spreads to the corporate market, there has been relatively little movement in corporate default spreads in 2025:
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Source: FRED |
The Rest of the Story
The economic shocks that hit the US markets, and which US equities and debt shrugged off, for the most part, also reverberated in the rest of the world. The broadest measure of relative performance between US and global equities is the divergence between the S&P 500, a proxy for US equity performance, and the MSCI World index, a stand-in for large cap international stocks, and the results are below:
In the first nine months of 2025, the MSCI global equity index is up 16.6%, about 2.3% more than the S&P 500 over the same period. However, all of this underperformance occurred in the first quarter of 2025, and the S&P 500 has found its winning ways again in the second and third quarters.
The MSCI index does obscure differences across regions and is titled towards large cap stocks. Consequently, we looked at all publicly traded equities, broken down by regions, with the values in US dollars, and the results so far in 2025 are in the table below:
US Equities: Overpriced or Underpriced?
None of the discussion above answers the question that we started this post with, which is whether US equities are overpriced. To make that assessment, there are a variety of metrics that are used, and while all of them are flawed, they vary in terms of what they leave out of the assessment, and the assumptions that underlie them.
At one end of the spectrum, the simplest and most incomplete metric is based purely on price history, with markets that have had extended good runs being viewed as overpriced. A modification is to bring earnings into the assessment, with prices moving disproportionately more than earnings (resulting in higher or lower PE ratios) considered a signal of market mispricing. The third adaptation allows for the returns you can make on alternative investments, in the form of interest rates on treasuries, to make a judgment on market pricing. The final and fullest variant considers growth in the assessment, bringing in both its good side (that it increases earnings in future periods) and its bad side (that it needs a portion of earnings to be reinvested), to make a pricing judgment, but even that variant ignores disruptions that alter market dynamics and risk taking.
1. Rising stock prices
For some investors, an extended stretch of rising stock prices is, by itself, sufficient reason to conclude that if stocks are doing so well, they must be over priced. This concern will get deeper as the market run gets longer (in terms of time) and steeper (in terms of price rise). Using that framework, you can see why talk of a stock market bubble has built up over the last decade, as stocks keep climbing walls of worry and hitting new highs. We have had a remarkable bull run in US equities over the last 15 years, with the S&P 500 up over 500% over that period:
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Download spreadsheet with historical returns on stocks |
In short, the annual return (18.74%) that equity investors have earned over the last fifteen years is significantly higher than the annual return (9.94%) on US equities over the last century. For some, this run-up alone is enough to decide that equities are overpriced and incomplete though this analysis is, you can see its draw for many investors.
2. The Earnings Effect
Looking at rising stock prices as an indicator of overpricing ignores the reality that markets can sometimes be up strongly, not because of speculation or over pricing, but because of rising earnings. That is the reason that many investors look at market pricing scaled to earnings, or PE ratios, and the graph below captures three variants of the PE ratio - the trailing PE, where you scale market pricing to earnings in the last twelve months, a normalized PE, where you scale the market pricing to average earnings over a longer time period (a decade) and a CAPE or Shiller PE, where you first adjust earnings for inflation and then normalize:
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Download historical PE ratios for US equities |
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- The first is that it treats stocks as if they were glorified bonds, treating the earnings yield like a coupon, and misses the reason that investors are drawn to equities, which is the potential for growth. Incorporating growth into the analysis has two effects, with the first being that you need reinvestment to grow, and that reinvestment comes out of earnings, and the second being the upside of increasing earnings over time.
- The second is that the earnings yield/ treasury bond rate differential has had a spotty record timing the market, missing much of the great bull market of the 1980s and 1990s, and clearly not providing much predictive power in the last two years.
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Download intrinsic value estimator |
The Market Timing Challenge
It is undeniable that this market is richly priced on every metric, from PE ratios to the earnings yield, net of treasuries, to intrinsic value measures like the equity risk premium, thus providing backing for Powell's assessment of equities as “fairly highly valued”. If you trust in mean reversion to historical averages, it seems reasonable to conclude that stocks are in fact overpriced, and due for a correction. In this section, we will examine why, even if you come to this conclusion, it is difficult to convert it into action.
Using lawyerly language, let's stipulate that markets are overpriced today, though that overpricing can cover a range of views from the market being a bubble to the markets just being expensive. There are five responses that you can have to this judgment, ranging from least aggressive to most aggressive on the market timing front:
- Do nothing: The essence of being a non-market timer is that you do not alter any aspect of your portfolio to reflect your market views. Thus, if your preferred allocation mix is 60% in stocks and 40% in your bonds, you stay with that mix, and you not only hold on to your existing investments but you continue to add to them in the same way that you have always done.
- Hold on to/ build cash holdings: For the most part, you match what you would have done in the do nothing response in terms of overall asset allocation mix and holdings, but you not only put your portfolio additions into cash (treasury bills, money market funds) but when you act, it will be more likely to be selling existing holdings (that you view as over valued) than buying new ones. For many equity mutual fund managers, this statistic (liquid assets and cash as a percent of assets under management) is a rough proxy of how bullish or bearish they are about the overall market.
- Change asset allocation mix: In this response, you revisit your preferred asset allocation mix, which was set based on your age, cash needs and risk aversion, and alter it to reflect your market timing views. Thus, if you believe that stocks are overpriced, but you view bonds as fairly or even under priced, you will decrease your allocation to the former, and increase your allocation to the latter. If you are constrained to be an all-equity investor, an alternate version will be to reallocate your money from overpriced geographies to underpriced geographies, if the latter exist.
- Buy protection: With the growth of options and futures markets, you now have ways of protecting your portfolio, without making wrenching changes to your asset allocation or holdings mix. You can buy puts on the index or sell index futures, if you think equities are overpriced, and benefit from the fact that the profits from these positions will offset the losses on your portfolio, if there is a correction.
- Make leveraged bets of market correction: The most aggressive way to take advantage of market timing is to make leveraged bets on market corrections, using either derivatives markets (puts or futures) or selling short on either all of the stocks in an index, or a subset of the most overpriced.
In making this choices, you do have to consider three real world concerns. The first is taxes, with any strategies that requires significant disruptions to existing portfolios, such as changing asset allocation mixes or selling overvalued stocks in the portfolio, creating larger tax bills. The second is transactions costs, which will also be higher for any strategy that is built around more aggressive. The third is timing, which is that even if you are right about the overpricing, being right too early may wipe out the benefits. Speaking of Alan Greenspan's warnings about the dot com bubble, it is worth remembering that his "irrational exuberance" comments were made in 1996, and that the market correction occurred in 2001, and any investor who sold equities right after the comments were made would have underperformed an investor who held on to equities and took the hit from the correction.
Let's assume that you remove taxes and transactions costs from the assessment to give market timing the best possible pathway to success. To test whether market timing works, you have to create a market timing strategy around your metric of choice, with three steps fleshed out:
- Choose your pricing metric: As noted in the last section, this can be the percentage increase in stock prices over a recent period, the current or normalized pricing ratio (PE, PBV, EV to EBITDA) or the equity risk premium/intrinsic value for the index.
- Create your action rule: The action rule specifies the threshold for the chosen metric, where you will act on your market timing. You could, for instance, decide that you will increase your equity exposure if the PE ratio is more than 25% below the median value for the market's PE ratios over the previous 25, 50 or 100 years, and reduce your equity exposure if the PE ratio is more than 25% higher than the median value over the period. Note that the trade off on setting the threshold is that setting it to a larger value (say 50%) will mean that you time the market less.
- Choose your market timing response: You specify how much you will increase or decrease your equity exposure in response to the market timing signal. Thus, if you have base asset allocation mix of 60% equities, 40% bonds, you can decide that if your threshold (from step 2) is breached, and the PE ratio drops (increases) by more than 25% below the median, your equity exposure will increase (decrease) to 80% (40%) and your bond exposure reduced (increased) to 20% (60%). The more aggressive you are as a market timer, the greater will be the shift away from your base mix. Thus, you could sell all equities (0% equities, 100% bonds) if the market is overpriced and hold only equities (100% equities, 0% bonds) if the market is underpriced.
To illustrate, let's use the Shiller PE, pick a 25% threshold for market cheapness and alter your asset allocation mix, which would normally be 60% equity/40% debt to 80% equities/20% debt if the Shiller PE drops 25% below the median (computed over the prior 50 years) and 40% equities/ 60% bonds if it rises 25% above the median.
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Download CAPE backtesting spreadsheet |
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Download CAPE backtesting spreadsheet |
Conclusion
The decision on whether to time markets is a personal one, and while I have concluded it does not work for me, it would be presumptuous to claim that it will not work for you. If you decide that market timing is part of your investment philosophy, though, there are three lessons that I hope that this post has highlighted. The first is that the more incomplete your market timing metrics are, the greater the chance that you will chasing a correction that never happens. It is the reason that you should be skeptical about arguments built around just pricing, PE ratios or earnings yields (relative to treasury bond rates), and even with more complete metrics, you should be scanning the horizon for fundamental changes in the economy and markets that may explain the deviation. The second is that the proof that a metric will work for you will not come from statistical measures (correlations and regressions), but from creating and back-testing an actionable strategy (of buying or selling traded instruments) based on the metric. The third is that even if you do all of this due diligence, market timing is noisy and flawed, and paraphrasing another widely used expressions, markets can stay mispriced for longer than you can stay solvent.
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Datasets
- Historical returns on stocks, bonds, bills, real estate and gold: 1927 - 2024
- PE, Normalized PE, Shiller PE and Earnings Yield Data for US Stocks: 1960-2025
- Shiller data on stock returns, interest rates and CAPE (monthly): 1871-2024 (from Shiller)
- Implied Equity Risk Premiums for the S&P 500: 1960-2025
Spreadsheets
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