The S&P 500 (^GSPC -0.38%) and the Nasdaq Composite (^IXIC -0.29%) have advanced 13% and 14%, respectively, year to date. The driving force behind those double-digit gains has been strong earnings growth, particularly among technology companies involved in the artificial intelligence infrastructure build-out.
However, by one valuation measure, the stock market is repeating a pattern last seen during the dot-com bubble. Is the AI boom destined to end in a catastrophic market crash? Of course, no one can predict the future, but here’s what investors should know.
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The stock market is repeating a pattern last seen during the dot-com bubble
The S&P 500 recorded a cyclically adjusted price-to-earnings (CAPE) ratio of 41.1 in August. The index’s CAPE ratio has now exceeded 40 in five consecutive months, something that has only happened once before: during the dot-com bubble in 2000.
The dot-com bubble peaked in March 2000. Irrational enthusiasm had pushed valuations on many speculative internet companies to unsustainable levels. Initially, the downturn was concentrated in the technology sector, but the losses eventually spread across all sectors as the economy slipped into a recession.
After peaking in March 2000, the S&P 500 had fallen 49% by October 2002, and it took the index seven years to recover its losses. It did not reach a new high until May 2007. Meanwhile, the Nasdaq Composite had fallen 78% by October 2002, and it took the index 15 years to recoup its losses. It did not reach a new high until April 2015.
Why the AI boom is not a repeat of the dot-com bubble
There are a few important differences between the dot-com bubble and the artificial intelligence boom. First, the internet became publicly available in the early 1990s, but it took over a decade to reach mainstream adoption. Generative AI became publicly available with ChatGPT in late 2022, and it has already reached mainstream adoption.
In fact, JPMorgan Chase strategist Justin Biemann says artificial intelligence is “one of the fastest-adopted technologies in history, with nearly one in four American firms deploying it at scale.” Also, Stanford University reports that consumer adoption of generative AI reached 50% within three years, while it took the internet twice as long to reach the same level.
Second, the internet boom was not accompanied by a significant acceleration in earnings growth because capacity exceeded demand. S&P 500 earnings growth peaked at 24% in 1998, and only 10% of the 39 million miles of installed internet fiber was actually lit by 2001. By comparison, AI demand greatly exceeds capacity today, and S&P 500 earnings are forecast to increase 31% this year.
Third, internet stocks experienced price appreciation that far exceeded earnings growth during the dot-com bubble, but the opposite has been true with the AI boom. Between 1995 and 2000, Cisco Systems stock increased 40x while its earnings increased 8x. But since 2023, Nvidia stock has increased 24x while its earnings have increased 45x.
Nvidia is not alone in that regard. Other companies at the center of the AI boom have also reported earnings growth that outpaces their stock price appreciation. Since 2023, Micron Technology stock has increased 18x while its earnings have increased 31x, Alphabet stock has increased 3x while its earnings have increased 4x, and Amazon stock has increased 3x while its earnings have increased 30x.
Here’s the big picture: The S&P 500 recorded a CAPE ratio of 41.1 in August, its most expensive valuation since September 2000. If history repeats itself, the S&P 500 and Nasdaq Composite will fall into deep bear markets within two years. But past performance is never a guarantee of future results.
The CAPE ratio is a backward-looking metric, so it does not account for the possibility that AI spending will drive a sustained acceleration in future earnings growth. But that is precisely what is happening today. This year, S&P 500 companies are projected to report the fastest earnings growth outside of a post-recession recovery in more than five decades, according to Wolfe Research. If that momentum persists, stocks should keep climbing higher.