Over the past 100 years, the S&P 500 index has delivered an average annual return of approximately 7%, adjusting for inflation and factoring in dividend reinvestment. However, the returns recorded in the last three years stand out as unusually high, primarily fueled by advances in artificial intelligence (AI) technologies. Between 2023 and 2025, the index appreciated cumulatively by 78%, a considerable acceleration relative to its long-term trend.
While some market participants argue that this momentum may persist, it is important to recognize that asset prices typically do not sustain such rapid appreciation indefinitely. This has led to increased attention toward valuation measures to gauge the market's underlying health and potential vulnerabilities.
Valuation Metrics: Beyond Traditional Measures
Common valuation tools include the price-to-earnings (P/E) ratio and its forward-looking variant. Despite their widespread use, these metrics have limitations, notably their inability to fully incorporate longer-term economic cycles and fluctuations in earnings power.
To address these issues, the cyclically adjusted price-to-earnings (CAPE) ratio offers a more comprehensive perspective. By averaging inflation-adjusted earnings per share over a ten-year span, the CAPE ratio normalizes for short-term anomalies and differing economic phases, providing a smoothed view of valuation extremes.
At present, the CAPE ratio hovers just below 40. Historically, the market has only approached this level on two notable occasions. The first was in the late 1920s, where a similarly lofty valuation preceded the subsequent market crash that ushered in the Great Depression. The other was during the late 1990s dot-com boom, wherein exuberant market sentiment drove the ratio to an all-time high of 44 before the internet bubble burst in 2000, precipitating a severe correction.
Assessing the Current Market Landscape
Given the CAPE ratio’s present elevation, there is reason to consider the possibility of a market downturn in 2026. Yet, important distinctions set the current environment apart from these prior episodes.
The late 1990s bubble was fueled by speculative investing in companies lacking established business models or viable internet strategies. Many firms merely capitalized on the promise of the internet without tangible plans or revenue streams, leading to unsustainable valuations.
In contrast, the current surge reflects genuine economic activity centered on AI. Major technology firms, often referred to as the "Magnificent Seven," currently commercialize AI across diverse areas including semiconductor manufacturing, enterprise software solutions, cloud infrastructure, e-commerce, autonomous machinery, robotics, and consumer electronics.
Moreover, hyperscale cloud providers intend to invest over $500 billion in AI infrastructure in the current year alone, indicating substantial and ongoing commitment to this transformative sector. This reality suggests that elevated stock prices tied to AI developments may be better justified than during prior speculative booms.
Outlook and Investment Strategies for 2026
While a prolonged market crash may not be the most probable outcome, the elevated valuations do raise the likelihood of a temporary market correction or pullback. Such a moderation could allow for a pause in recent price advances and offer opportunities for portfolio adjustment.
Given these dynamics, investors may consider proactive portfolio management by:
- Reducing Exposure to Speculative, Unprofitable Stocks: Companies lacking established profitability and relying on future growth prospects tend to be most vulnerable during corrections, often experiencing the steepest valuation declines.
- Maintaining Holdings in Blue-Chip Stocks: Firms with durable and resilient business models tend to weather market downturns better and provide a basis for stability across a diverse portfolio.
- Increasing Cash Reserves: Building liquidity positions can enable investors to capitalize on market dips, purchasing undervalued assets when prices retreat.
These strategies align with a cautious, yet balanced approach that recognizes both the risks signaled by historic valuation levels and the fundamental strengths underpinning the current market environment.