Are US equity prices irrational?

The famous economist John Maynard Keynes once observed that the markets can stay irrational for longer than you can stay solvent. He made this comment after making losses on stocks by following the economic fundamentals and rational analysis.

By many indicators, stock market prices in the US are over-valued. Ratios of prices to underlying earnings are close to all-time highs. On 6 January, the S&P 500 reached 6,000, having added $900 billion in 2025, before the year was a week old. The price-to-book ratio of the Index – the proportion of a stock market valuation to the aggregate asset value of the listed companies – hit a record high of 5.3, which compares with a long-term average of around 3.0. The ratio nears 30.0 for some tech and consumer discretionary stocks. The top 10 stocks account for around 40% of the S&P Index by value.

The US stock market accounts for 73% of global value as measured by the MSCI World Index at end 2023, compared with a figure of just 26% as the proportion of global GDP made up by the US economy – although of course many of the US-listed companies operate globally.

Outsize profits at a small number of tech firms could be vulnerable to being chipped away. At the same time, it is difficult to assess the ultimate impact of new AI applications, and the USA is home to the most significant providers – not only of the applications, but of the hardware that drives them.

Investors are enthused by the pro-business attitude of incoming President Donald Trump. Policies of lower taxes, deregulation and fiscal looseness appear to be pro-growth. It is assumed that these policies, combined with the potential of new technologies, will outweigh potential drags on growth – which could include some of Trump’s other policies, namely import tariffs, which hinder trade, and anti-immigration policies, which could lead to worker shortages and wage inflation. The assumption is that Trump will be pragmatic and not impose the highest tariffs or the strictest measures on deporting undocumented immigrants. When he was President in his first term, he made many announcements about completing a wall on the Mexican border to inhibit immigration – but the wall was never finished.

Even if he moderates his policies, there are economic uncertainties and risks. The US deficit is huge and this is another factor the markets are downplaying, in part because of the size of the US economy and the dollar’s status as reserve currency. The deficit is 6.4% of GDP, and the debt level is over 120% of GDP. Nothing in the Trump policy mix indicates a fiscal correction. Yields on ten-year Treasury bonds rose from 3.6% in September 2024 to 4.6% by the end of the year.

As regards the stock market valuations, one of the factors that sustains the apparent bubble is the question: where else is the money going to go? Europe is deflated, China is also struggling and emerging markets have disappointed on growth in the past and do not yet hold sufficient potential. The bond markets are already well invested; globally, money supply is continuing to grow.

There could be a ‘Black Swan’ event in the economic world or geopolitics that pricks the bubble and causes a crash similar to those of 1929, 1987 or 2008, or it is just possible that the US truly is exceptional, its tech firms are uniquely placed to continue making exceptional profits as the AI revolution evolves.

As 2025 begins, the bullish voices have been quieter, if not silenced. A sobering combination of inflation nudging upwards, to 2.9% with the likelihood of further rises owing to import tariffs, has all but snuffed out any hope of interest rate cuts – there may even be a rise this year. Equity prices have fallen from their peak in November, with the S&P down by $2.5 trillion market capitalization in a four-week period over December and January.

This could just be a pause in the bull run, similar to those in the past couple of years. No other markets offer a compelling alternative for investors’ money.

One possibility for US equities and the wider economy is neither a boom nor a bust: that the bubble deflates slowly as inflation nudges upwards and interest rates are held or increased; the US economy grows at unexceptional levels but avoids stagflation. It is not the most dramatic outcome, but it makes sense to be prepared for a range of different scenarios. Events are unpredictable, and so is Donald Trump.