Markets Look Strong and Wall Street is Wrong About the 'Lost Decade'

This year’s stock market gains have been heavily driven by Big Tech companies investing significantly in artificial intelligence, creating substantial market volatility both before and after the U.S. presidential election. Despite these fluctuations, U.S. equities remain a viable long-term investment option. The S&P 500’s price-to-earnings (P/E) ratio currently stands at around 30, slightly above its 25-year average of 26 and higher than the 27 recorded during the business cycle peak in February 2020.

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Although the current P/E ratio may appear high, U.S. companies are improving in both efficiency and profitability. According to FactSet, projections for fourth-quarter 2024 show sales growth of 4.8% and profit growth of 12.2%. By 2025, these figures are expected to rise to 5.7% for sales and 14.8% for profits, suggesting a favorable environment for corporate performance.

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Goldman Sachs analysts recently caused a stir with their forecasts based on the Cyclical-Adjusted Price-Earnings (CAPE) ratio, developed by economist Robert J. Shiller. Their analysis suggests that U.S. stocks may face challenges over the next decade, potentially making bonds a more attractive option. CAPE measures stock prices against inflation-adjusted average earnings over the past 10 years. At nearly 38, the current CAPE ratio far exceeds its 25-year average of 28.

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However, critics argue that the CAPE ratio’s 10-year timeframe is somewhat arbitrary and doesn’t align with the typical length of U.S. business cycles. The most recent expansion lasted 146 months until the pandemic-triggered shutdowns. Current CAPE calculations also reflect depressed profits due to the extraordinary economic downturn caused by COVID-19. Over the years, markets have trended toward higher average P/E ratios. For example, the S&P 500’s P/E ratio averaged about 15 during the 25 years leading up to 1999.

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Moreover, bearish signals from CAPE are not always predictive. In September 2021, CAPE computations suggested caution, yet the S&P 500 has risen more than 25% since that time.

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Challenges for Big Tech

Goldman Sachs also points out that large companies often struggle to sustain rapid revenue and earnings growth over extended periods. Dominating their markets makes it harder for these firms to attract new customers, while increasing scrutiny from competitors and government antitrust regulators adds to their challenges.

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Historical examples highlight this phenomenon. During the late 1960s and early 1970s, the Nifty Fifty stocks drove significant market gains, but the 1970s became a lost decade for equities. Similarly, the late 1990s tech boom led by Microsoft, Cisco Systems, and Intel was followed by sluggish returns in the 2000s.

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Today’s market leaders, often referred to as the Magnificent Seven—Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla—make up approximately one-third of the S&P 500. They also account for about half of the index’s gains this year. Beyond these giants, companies like Salesforce and Adobe are also gaining attention. Both have expertise in business software applications and are capitalizing on AI agents—specialized tools designed to enhance productivity and reduce labor costs.

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Investment Strategies

For individual investors, the core advice remains consistent: live within your means, maintain an emergency fund, and allocate cash for significant expenses in money market accounts or fixed-income instruments like U.S. Treasuries and certificates of deposit (CDs). The remainder of your portfolio should be invested in diversified individual stocks or low-cost, broad-based index funds. Examples include the Vanguard Total Stock Market Index Fund (VTSMX) or its exchange-traded counterpart, the Vanguard Total Stock Market ETF (VTI).

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Diversification allows investors to benefit from overall economic growth and the emergence of new, profitable companies. The rise of AI is expected to play a crucial role in this growth. A report from Bain & Co. estimates that spending on AI equipment and services will soar from $185 billion in 2022 to nearly $900 billion by 2027. Goldman Sachs research further predicts that AI could increase U.S. labor productivity by about one percentage point annually.

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The AI Revolution’s Impact

The widespread adoption of AI is expected to reshape industries and create significant economic opportunities. While many jobs will be disrupted, the broader U.S. economy is likely to experience a growth trajectory closer to 3% annually, compared to the current 2%. This transformation won’t just benefit the tech giants we recognize today. Instead, a new wave of innovative companies is poised to emerge and thrive.

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In summary, while market valuations and CAPE ratios may raise questions, the long-term outlook for U.S. equities remains optimistic. By focusing on diversification and embracing the growth potential of AI-driven innovation, investors can position themselves to benefit from the evolving economic landscape.

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