Valuation Schmaluation
As I’m writing this (September 22nd), the Shiller (CAPE) ratio has just cleared 40x cyclically adjusted earnings for the first time since 2021.
This has happened only 3 times in history - 1999, 2021, and now 2025.
This isn’t to say that a market crash is inbound, necessarily, but as valuation metrics approach record highs, it makes sense that we take the temperature of the market.
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Vibes. Market sentiment definitely does feel frothy at the moment. We’ve had ripping markets basically since the summer of 2022, with only the tariff scare in 2025 acting as a very minor speed bump. But sentiment feels different now than it did in 2021, which I could describe only as a pure mania. Post Covid, market participants were going wild over NFTs, meme stocks, and SPACs. Facebook was sinking billions into the Metaverse, changing their company name to reflect that bet. And there were even weird marketplaces cropping up for trading concert ticket stubs.
Today just ‘feels’ different. Less euphoric. Sure, there are still some meme stocks. Most recently, Opendoor’s stock has blasted off to the tune of a 20-bagger in 3 months. And IPOs are starting to pick up. But I don’t get the same sense of frenzy that we had in 2021 - I wasn’t investing in 1999, but I assume that period felt closer to 2021 than it does today.
Even SPACs of recent past aren’t exorbitantly priced. Quantumscape, a company that I follow in my other letter, is still priced 90% lower today than they were in 2021 despite a lot of de-risking and being much closer to commercialization. Joby, another company that I cover, just recently cleared their 2021 high while being only months away from starting their commercialization effort. It’s certainly possible that these companies are overvalued today (and they definitely didn’t deserve the premiums they traded at in 2021), but I think I can make a compelling case to the contrary…which by definition, means that they’re probably not euphorically overvalued.
Other stocks may have taken up the mantle on the hype train - Oklo, Palantir, etc. - but while you can certainly make the case that they are severely overvalued - though they may not be as overvalued as their PE ratios would indicate - it takes much broader market participation to bring down the market as a whole. You’ll always have some stocks that look expensive.
And of course AI is seeing a lot of enthusiasm. But again, if you think AI is overvalued, you can just not own it. The S&P 500 and Nasdaq would obviously suffer, but I don’t think if everyone decided to become clear-headed about AI tomorrow, it would result in a 2000 style meltdown.
I’ve also seen a lot of arguments that the CAPE ratio is no longer a valid metric. You’ll hear arguments like “It’s been going ‘up and to the right’ for decades” or “profit margins are stronger” or “US companies are no longer susceptible to business cycles”.
At the end of the day, earnings are earnings. Maybe earnings were more choppy in years past, but that’s why we smoothed them out. Comparing smoothed-out volatile earnings to smoothed-out placid earnings accomplishes the same thing - both are business cycle agnostic. This is already an apples to apples comparison.
Maybe you can make the case that today’s companies deserve a premium valuation. Margins are indeed better and balance sheets are practical fortresses which does add a ton of buffer in terms of operating leverage. I would say that’s all fine. But a premium valuation is an implicit sign of safety…which is explicitly correlated with expected returns. Lower risk means lower returns. Full stop.
And you might also bring up earnings growth, which is also fair. But if you project 10%+ earnings growth out into perpetuity, then there really is no price too high. Let’s see 60x earnings if that’s the case.
There is a path to higher short term earnings that will correct the PE ratios without bringing prices down. But again, what probability would we assign to that over this being like every other time valuations have been this stretched? And recent earnings growth isn’t unique relative to history.
My assessment of overall market sentiment is one of complacency and enthusiasm, not euphoria…at least for now.
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On the economy. Tariffs definitely suck money out of the economic engine. But if deficits continue to increase to offset that drag, then there will be no net change to GDP. Government spending is a direct input into GDP. And tariff impacts are secondary. As long as that money is still circulating, tariffs only affect corporate profit margins and the inflation component of GDP. On a nominal basis, consumption doesn’t really change or maybe even increases. I think this is understated. There exists a scenario where we may even get a technical recession due to inflation (demand falls only in real terms), while the underlying economy remains pretty resilient on a nominal basis.
The way this administration has implemented tariffs simply acts as a redistribution mechanism to siphon money from one place, namely end consumers and corporate bottom lines, and redirects it to their areas of interest.
The dollar weakening is another story that’s top of mind. At surface level, this is another drag on importers which amplify our tariff woes. But it helps exporters and domestic producers. If fiscal policy is aimed at decreasing imports and increasing exports, this will undoubtedly aid in that effort (as long as we have willing trade partners).
And maybe most importantly: interest rates. The interest payment on the national debt is 3.1% of GDP and a whopping 17% of the federal budget. Rates coming down will help that. Whether they use those savings to reduce the deficit or pile it into more fiscal spending is another story. On the former, net impact on GDP is probably slightly negative as less money is entering the economy. Interest payments aren’t directly captured in GDP to begin with, so the impacts only show up after the lender spends those coupons and redemptions on a good or service. If the administration chooses to keep deficits where they are, the net impact on GDP is positive - just the destination changes from money market accounts to directed government spending. And of course this would come with it’s own multiplier effects.
In general, money jostling around in secondary markets aren’t a value add to the economy. So if interest payments decline and government spending climbs to offset, that’s going to show up in a tangible way. Note, this impact may not be measurable since interest payments are only 3% of GDP.
And then there’s the question of what happens to the long end of the yield curve. Long duration bond yields are a function of short-end expectations, inflation, and expected returns of alternatives.
The former explains why we’ve had a flat-to-inverted yield curve for the past 3+ years. The FFR (fed funds rate) was always expected to come down eventually so why would the long end price as if FFR was going to stay elevated forever. As FFR and short duration bond yields come down, the “term premium” should return and long duration bond yields could remain a little sticky. They may (and probably will) follow downward a bit, however.
In terms of inflation. I think the effect here is overstated. Real yields have historically been negative both in the U.S. and abroad for very extended periods. Just because the dollar loses value doesn’t mean that bonds have to act as a hedge against that. Long-end yields are only impacted by inflation insofar as it’s expected impact on the FFR.
The latter is also a big component. All assets price off of each other. So if equities continue to climb, it’s possible that yields drift down in lockstep. If the opposite happens, and yields drift up while equities climb, that reflects an interesting investment opportunity as bonds begin to look more attractive relative to equities. In 1999, bond yields topped 6% while the CAPE ratio climbed above 44x. We’re still a ways away from that.
Yields can also fall in a stock market crash. This is more mechanical as supply / demand for bonds drive price action during a “flight to safety”.
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So what should prudent investors do?
Valuations are definitely stretched based on pretty much every metric. However, the economy seems fine, interest rates are coming down, and government spending doesn’t seem to be slowing. I don’t see a direct line of sight on a recession, and thus, I don’t expect a market crash. But it also seems irresponsible to try and catch the very last bid in a bull market. I think the answer is what it’s been for a while: just diversify, rebalance every once in a while, and hold.
I still very much like developed international markets. Priced at 17x trailing earnings, I don’t see why they shouldn’t continue to return 8-12% in local terms (in their own currencies). This is what we’ve seen this year and years past in funds like HEFA which hedge out currency movement. On an unhedged basis, funds like VEA and EFA have returned 25% this year on the back of the weakening dollar while underperforming in years past due to the strong dollar. I don’t really have any insight into what currencies might do going forward, so I like the idea of holding both. The correct allocation split between hedged and unhedged is another topic on it’s own.
International equities also get a lot of hate from people that I admire. You’ll hear things about anemic EU growth and their economies being in shambles. But… Higher returns do come from higher risk. Earnings growth has remained positive. The economy is not the stock market. And they’re certainly not priced for euphoria. Markets climb a wall of worry, so why should this be any different. I certainly wouldn’t place all my chips into one basket, but it seems reasonable to hold a healthy allocation here.
In terms of making moves. If you’re happy with your asset allocation, but feel compelled to do “something” about impending (potential) underperformance, one first step might be to look at asset location. If we expect U.S. markets to underperform, maybe we lean those holdings towards our traditional 401k and IRA accounts, while holding international in Roth accounts. If we’re “right” and US underperforms, our tax liability in the future is lower than it otherwise would have been. If we’re wrong, and US markets continue to scorch the rest of the world, then at least we weren’t sitting on the sidelines. But maybe that’s just getting too cute.