Unconventional wisdom: The market is expensive. I’m still investing
The arguments for a market bubble are compelling. So are the arguments against it. Here’s why you shouldn’t bet heavily on either outcome.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The market is expensive. I’m still investing
It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness...
- Charles Dickens
Maturity is accepting there can be truth in two conflicting ideas at the same time. Dickens quote captures this inherent paradox of life. And as an astute observer of human behaviour Dickens surely knew how much humans struggle to accept this truth.
People are more comfortable retreating into echo chambers. It explains why we are drawn to bombastic and uncompromising advocates who reinforce what we already believe. Politics may spring to mind - but the investing world can be just as polarised.
The debate over the AI ‘bubble’ is illustrative of this phenomenon. Will the best of times continue or are we on the precipice of the worst of times? There are passionate and outspoken advocates for each position.
I find this debate interesting in an academic sense. And my worldview makes the bubble argument seem more compelling. But like many readers I need to be pragmatic.
I’m not Michael Burry or Cathie Wood. I have neither the inkling nor ability to bet it all on one outcome.
Achieving my goals requires the long-term returns that only the share market can deliver. But I’m also old enough and financially comfortable enough to dread the consequences of a catastrophic investing mistake.
Being wary is frowned upon in both the financial services industry and wider society. People expect confidence even when it is just a façade. But I’m happy to admit that I do worry.
I worry about valuation levels and signs of excess. To be a productive worrier I’ve outlined the main argument we are in a bubble – mean reversion – and the argument against it. I hope this exercise is useful for anyone else unsettled by the current environment.
Mean reversion
In my squash league I join other middle-aged unathletic men as we battle the loneliness epidemic while trying not to hurt ourselves. This week I took on an opponent ranked much higher than me and it was obvious during warm-ups that I was in over my head.
In the first point of our match my opponent hit a blistering serve to my backhand. To everyone’s surprise – including my own - I hit a wall hugging return which drippled into the corner before my opponent could get anywhere close to it.
Was this the start of a thrilling win? It was not. Most of my opponent’s serves were strong and most of my returns were poor.
After that first point our levels of play reverted to the mean. He was better than me and over a larger sample size the skill differential had more influence over the result than the randomness of any point.
Recency bias influences decision making as investors tend to expect what is happening now to continue. Many investors focus too much on the last data point and don’t seek a wider perspective. It is the equivalent of watching the first point and assuming I would win the match.
Many people who insist we are in a bubble argue that if you zoom out you start to see our current conditions are a historical outlier. Often two data points are cited – valuation levels and net profit margin. These are the data points the bubble advocates insist will revert to the mean.
Mean reverting valuations
The cyclically adjusted price to earnings (“CAPE”) ratio compares share prices to the average inflation adjusted earnings over the past 10-years. Using a 10-year average introduces some conservatism to the measure and smooths out the cyclicality of earnings.
In May the CAPE ratio for the S&P 500 came in at 40.16. Without context this figure means little. But conveniently Professor Robert Shiller has monthly CAPE data on the S&P 500 dating back to 1881.
Breaching 40 is significant because the first time the CAPE ratio was over 40 was the period starting in January 1999. That was a little over a year before the dotcom crash. After the crash the CAPE ratio never breached 40 again…until May.
The S&P 500 is as expensive as it has ever been and reverting to the mean would require a steep market drop or meaningful increase in earnings. The average monthly CAPE ratio over Professor Shiller’s 145 years of data is 17.75.
Profit margins
A bubble is often characterised as a time when investors are obsessed with revenue growth without bothering to figure out if a business can ever make money.
When profits remain elusive the bubble bursts. That is the origin of the business maxim ‘revenue is vanity and profit is sanity.’
To refute bubble claims many people point out that tech companies are profitable. The bubble advocates have a retort.
The S&P 500 net profit margin which measures the percentage of revenue made up of profits is at an all-time high. According to CBS MarketWatch the Q1 2026 S&P 500 net profit margin is 13.4% which is double the index’s 6.3% average since 1946.
If net profit margin reverts to the mean earnings will fall significantly.
The impact of valuations and profit margins reverting to the mean
The reversion to the mean argument is compelling. The market is selling at more than twice the historical earnings multiple and net profit margins are double the historical level.
If both measures fully revert to the mean the S&P 500 would trade at 1,646 which is 78% below the current level. That is an extreme scenario. But if one – or both – even partially revert to the mean it would result in a big market drop.
The counterargument to reversion to the mean
There is a Chinese proverb about the Bamboo Tree. A farmer plants a Bamboo Tree in the soil and for years nothing perceptible happens. But the Bamboo Tree is growing beneath the soil and once it breaks the surface it sprouts to ninety feet in six weeks.
In the years when no change is evident, the tree builds a root system to support remarkable future growth. Small and imperceptible changes lay the foundation for extraordinary growth.
If reversion to the mean was a universal law of nature there would be no societal progress. Our lifespans wouldn’t change. Our living standards wouldn’t increase. There would be no compounding of outcomes.
A deeper exploration of valuation levels and net profit margins adds nuance to the reversion to the mean argument.
Steadily increasing valuation levels
The following chart shows the average monthly CAPE ratio for the S&P 500 by decade since the 1970s.
This next chart shows the average annual net profit margin for the S&P 500 by decade since the 1970s.
The pattern is similar with steady increases in both the CAPE ratio and net margin starting in the 1990s. This shift can be interpreted as a giant bubble or a rational response to changing conditions.
There is a case to be made for the latter – and I say this reluctantly as someone who eschews ‘this time is different’ arguments.
What if several underappreciated and barely perceptible changes in business and economic conditions have profoundly altered the investing landscape? Progress we haven’t noticed like the Bamboo Tree growing underground.
Technology and automation have made all businesses more efficient. Companies are more effectively using data to optimise their operations and improve decision making. Globalisation has lowered costs while just in time production lowered inventory levels.
All of these factors have slowly but surely improved companies. There has also been a profound shift in the economy from manufacturing to asset light and scalable technology enabled companies. Perhaps AI will lead the next efficiency wave.
Companies today are better than companies in the past as demonstrated by the net profit margin. It is rational for investors to pay more for better quality businesses.
Is this a bubble?
I don’t know and neither does anyone else. But I do know that every person’s views are shaped by their temperament, experience and - in some cases - their self-interest.
Some investors are naturally pessimistic and can’t imagine things not going wrong. These investors have predicted 45 of the last 2 bubbles. I struggle to keep these tendencies at bay.
Some are perpetually optimistic and keep discovering that many a tempting oasis is just another mirage.
Both groups sell themselves as realists who ‘tell it as it is’ while painting those with opposing views as corrupt and ignorant. But this simplistic positioning ignores the reality of the situation.
The data is more nuanced than many passionate advocates of either view will admit. The likely outcomes are far less extreme.
I think valuation levels and net profit margins are high and will come down – but not to those long-run historical averages which are often quoted in doomsday scenarios.
I accept that there can be wildly speculative parts of the market and the right decision can still be to stay invested.
Living with cognitive dissonance is far harder than retreating into the safety of perceived certainty. But the middle road has often paid off far more than extreme views.
Final thoughts
This can be a confusing time for pragmatic long-term investors. But if you are an investor – like me – that has goals to achieve you need to keep plugging along.
Achieving a goal isn’t about being right or wrong. It isn’t about adhering to the idealized stereotype of a high conviction, concentrated investor who goes on all in on their view.
I’m not going to cash nor am I stocking up on geared ETFs. I’m not betting my future on a particular outcome.
I’ve trimmed some positions in shares tied to the AI infrastructure build to add to positions that have been left behind. I’m still fully invested but in line with my strategy which has little overlap with many of the AI plays.
If the AI rally continues, I won’t fully take part given the holdings in my portfolio. If a bear market starts, I will likely outperform.
This is the middle ground and I’m at peace with leaving some returns on the table for more safety on the downside. I can afford to be patient with achieving my goals. I can’t afford to get an extreme bet wrong.
Do you think we are in a bubble? And if so, what are you doing about it. Email me at mark.lamonica1@morningstar.com
I am doing a series of webinars on ETFs coming up. Sign-up for the second one here.
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What I’ve been eating
Somebody should convene a Royal Commission on the lack of venison on Australian menus. This condition of scarcity explains my Pavlovian response to the venison meatball special at Pitzi in Hobart. The meatballs covered in cheese and tomato sauce were great. But they also got me thinking.
Venison meatballs are typically made from the shoulder, neck or leg. That leaves some great cuts if the restaurant purchases the entire deer. And Pitzi is the sister restaurant of my favourite restaurant in Australia - Fico. I had a booking two days later and sure enough there was an amazing venison saddle on the tasting menu. My personal – and pointless – code of conduct prevents me from posting about Fico again but don’t leave it off your list.
