The Role of Artificial Intelligence in the Market Boom

The year 2024 has proven to be an exceptional one for investors in the U.S. stock market, with the S&P 500 index, which tracks the largest publicly traded firms, rising by 54% compared to two years ago. This significant increase continues a trend that began in 2023 and marks one of the best performances since the index’s inception in 1957. While there have been some brief setbacks, such as a 3% drop on December 18 following the Federal Reserve's decision to lower interest rates less than expected, the overall mood remains optimistic. Notably, stock markets worldwide have also risen, although the U.S. market has vastly outpaced its global counterparts, piggybacking on the AI boom

Much like the dotcom bubble of the late 1990s, the surge in stock prices today is fueled by a belief in a new technology—artificial intelligence (AI)—that investors hope will generate substantial future profits. While the dotcom boom was driven by the promise of the internet and telecommunications, today’s optimism revolves around AI’s potential to revolutionize industries and boost corporate earnings. However, this raises the critical question: Are investors’ expectations rational, or are they simply riding a speculative wave that could eventually crash?

Measuring Investor Sentiment

To gauge the level of investor enthusiasm, three key indicators are particularly telling. The first is sentiment among individual investors. According to the Conference Board, a research organization that surveys American consumers, 56% of respondents believe stock prices will rise over the next year. This is the highest level of optimism recorded since the survey began in 1987, signaling strong belief in the market’s future performance. Similarly, a survey by the American Association of Individual Investors shows significant optimism, though not at record levels. This bullish outlook, particularly among retail investors, has been a significant factor in driving the market’s upward trajectory.

Institutional investors, such as fund managers, appear to be betting on a stable market in the short term. The VIX index, which measures market volatility, had reached unusually low levels before the December sell-off. This suggests that professionals are not anticipating major fluctuations in the near future. However, this also implies that much of the optimism may already be priced in, with less room for growth if the mood shifts suddenly. If the market were to experience a shift in sentiment, it could lead to a rapid downturn.

Record Inflows into U.S. Stocks

A third measure of market enthusiasm is the record amount of capital flowing into U.S. stocks. Bank of America’s monthly survey of global fund managers shows that U.S. equities are at their most “overweight” position ever. In December 2024, fund managers reported their highest-ever allocations to American stocks. Additionally, $450 billion was invested in funds that focus on U.S. stocks in 2024, with another $30 billion directed into small-cap U.S. firms—both record amounts. As a result, equities now make up an unusually large portion of investor portfolios, signaling that the market may be reaching a saturation point. On the retail investor side you can see that since the beginning of this year and 2022 there has been a downtrend on cash reverses which where used to buy up equites. Further increases in stock prices will likely require even more capital, and finding willing buyers could become more difficult.

Valuations: A Cause for Concern

While the inflow of capital has contributed to rising stock prices, the underlying valuations of these stocks are becoming increasingly concerning. The cyclically adjusted price-to-earnings (CAPE) ratio, a commonly used measure of stock market valuation, is at historically high levels. At the end of 2024, the CAPE ratio for the U.S. stock market was higher than at almost any time in the past 120 years, with the only exceptions being the dotcom bubble and a brief period in 2021. This suggests that stocks are significantly overvalued relative to the profits they generate, which raises concerns about the sustainability of future returns. Historically, when the CAPE ratio has been this high, subsequent returns have been much lower.

The Narrowing Yield Spread

Another worrying sign is the narrowing yield spread between riskier corporate bonds and safer government debt. The difference in yields between high-yield corporate bonds and Treasury bonds is the smallest it has been since 2007, suggesting that investors are willing to accept lower returns for riskier assets. Similarly, the gap between investment-grade bonds and government debt is at its lowest since 1998. These signals indicate that investors are overly optimistic about the prospects for risky assets, which could lead to trouble if economic conditions worsen.

Comparing U.S. Valuations with Global Markets

A comparison of U.S. stock market valuations with those of other countries highlights just how extreme the U.S. market has become. The CAPE ratio for European stocks is less than half that of U.S. stocks, and the gap between the two is at a multi-decade high. Moreover, U.S. firms now represent 70% of the total market value of developed market stocks, another multi-decade high. This concentration of market value in U.S. equities is a sign of an increasingly imbalanced global market. Even within the U.S. stock market, a small number of companies are driving the majority of the growth. The top ten firms in the S&P 500 now account for 40% of the index’s total value, up from less than 25% five years ago. This concentration of value in a few firms raises concerns about the broader health of the market.

America’s National Debt: A Growing Concern

Parallel to the stock market’s rise, the U.S. faces a growing fiscal crisis. The country’s national debt has been steadily increasing for decades, and with rising interest rates, the cost of servicing this debt is also growing. The U.S. government is running annual deficits approaching $2 trillion, even with positive growth and low unemployment. These large deficits are unsustainable in the long term and could eventually trigger a fiscal crisis. If the economy enters a recession, tax revenues would fall, making it even harder to manage the growing debt. This could lead to further borrowing and money-printing by the Federal Reserve, exacerbating the problem.

As the national debt continues to spiral, the U.S. government will eventually face difficult choices. One likely scenario is dollar debasement, where the government prints more money to pay off its debts. Alternatively, the government may pursue a form of debt restructuring, which could involve partial default or renegotiation of the country’s debt obligations. Such actions could lead to inflation or a devaluation of the dollar, affecting both domestic and global markets.

Could the Market Crash?

Despite these troubling signs, there is no certainty that the U.S. stock market will crash in the near future. There are several factors that could continue to drive stock prices higher, such as the return of former President Donald Trump, who has promised tax cuts and deregulation, or the continued growth of AI. However, the current market boom is underpinned by risky valuations and the possibility of a correction or deflation of the bubble.

While the U.S. stock market’s performance in 2024 is impressive, it is underpinned by high valuations, extreme investor optimism, and growing economic risks. The potential for a market correction remains high, especially if the broader economic environment worsens or if investor sentiment shifts. Meanwhile, America’s national debt poses a significant long-term threat, with the possibility of fiscal instability looming on the horizon. Investors must remain cautious, as the current boom may not be sustainable in the face of rising debt and inflationary pressures.