• US equity market valuations are at levels last seen during the post-Covid rally and the dot-com bubble.
• Diversification across global equity markets, where valuations are at fair-value, can help reduce risk.
• An exposure to global bonds through a low-cost multi-asset solution can further mitigate any volatility in equity markets.

Developments in artificial intelligence (AI) technology have created excitement and helped propel US stock valuations to levels not seen since the dot-com bubble in the late 1990s and early 2000s¹. Many investors believe AI will make companies more productive, more efficient and the technology will lead to new innovations. 

Vanguard research suggests developments in AI will be vital in offsetting a demographic-driven growth deficit over the coming decades. Our experts assign a 30%-40% probability that age-related government spending outweighs AI-led productivity; and a 45%-55% likelihood that AI drives productivity gains beyond that of the personal computer and the internet.

While those investors that expect AI to drive a new era of economic growth may well be proved right in the long run, parallels between the dot-com bubble and today's excitement around AI offer a cautionary tale about the importance of portfolio diversification for long-term investors.

A cautionary lesson from the dot-com bubble

Valuations serve as a reliable predictor of future equity returns, which doesn’t bode well for the US stock market. The chart below shows a common metric for valuing the US equity market, the cyclically adjusted price/earnings (CAPE) ratio. To smooth out the impact of economic cycles, it considers current share prices in the context of 10-year inflation-adjusted earnings per share. In January 2024, the CAPE ratio for US equities was more than 30, higher than at almost any other time during the past 70 years.

The range of fair-value for US equities, shown in the grey-shaded area, is Vanguard’s calculation using macroeconomic variables, such as interest rates, inflation and market volatility. Over the long term, CAPE valuations tend to fall within or stay close to the range of fair-value. 

Even the transformative potential of the internet couldn’t prevent the dot-com bubble from bursting around the turn of the millennium as valuations came down to fair-value.

The risk of a correction in equity prices has risen as valuations have become more stretched 

Past performance is not a reliable indicator of future results.

Notes: Vanguard’s US fair-value CAPE is based on a statistical model that adjusts CAPE measures for the level of inflation and interest rates. The statistical model specification is a three-variable vector error correction that includes equity-earnings yields, 10-year trailing inflation and 10-year US Treasury yields estimated from January 1950 to January 2024. Details were published in the 2017 Vanguard research paper Global Macro Matters: As US Stock Prices Rise, the Risk-Return Trade-off Gets Tricky. A declining fair-value CAPE suggests that higher equity-risk premium (ERP) compensation is required, whereas a rising fair-value CAPE suggests that the ERP is compressing.

Sources: Vanguard calculations, based on data from Robert Shiller’s website, the US Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv and Global Financial Data. Data between 1 January 1950 to 1 January 2024.

However, it's important to note that although current valuations are elevated, this doesn't preclude them from climbing further in the short term. It's crucial to remember that valuations should not be used as a tool for timing the market. Moreover, even over longer periods, valuations do not consistently predict whether investments will perform well or poorly.

That said, we believe US valuations are likely to come down towards fair-value through falling share prices over the coming years. Regardless of AI’s potential – much like the emergence of the internet in the late 1990s – market valuations tend to revert to fair-value.

Not all markets are overvalued

The picture is more mixed when we zoom out and take a global view of stock market valuations. As the chart below shows, of the world’s major stock markets only the UK and US fall within the stretched category. UK valuations are stretched mainly because our estimate of fair-value came down as interest rates rose through 2023. The coloured dots represent our most recent assessment of valuations while the white dots show valuations at the end of September 2023. 

Most equity valuations have edged higher in recent months 

Past performance is not a reliable indicator of future results.

Notes:The charts show current (end-of-February 2024) valuation percentiles relative to fair value, compared to Q3 2023. The equity valuation measures are based on the end-of-February 2024 cyclically adjusted price/earnings ratio (CAPE) percentile relative to the fair-value CAPE for the MSCI USA Broad Market, MSCI UK MSCI EMU, MSCI Japan indices. (*) The emerging markets valuation measure is based on the percentile rank based on our fair-value model relative to the market, and current valuations are for 31 December 2023.

Source: Vanguard calculations, based on data from Robert Shiller’s website, at aida.wss.yale.edu/~shiller/data.htm, the US Bureau of Labor Statistics, the Federal Reserve Board and LSEG (formerly Refinitiv), as at 30 September 2023, 31 December 2023 and 28 February 2024.

Broadly speaking, equity valuations have edged higher since the end of Q3 2023, but investors are still buying at fair-value in the euro area and Japan, while emerging market equities remain undervalued. It’s also worth noting that despite UK valuations being stretched, the market is closer to fair value than it was last year.

With valuations outside the US looking generally more attractive, the case for maintaining a globally diversified exposure to stock markets remains strong. 

Hedge against equity market volatility with global bonds

As well as diversification across global stock markets, investors might want to consider their exposure to global bond markets because bonds have typically acted as a ballast against equity market volatility, with bond prices rising—or falling less sharply—during periods when stock prices are falling².

On top of the risk-dampening qualities of bonds, Vanguard’s long-term return outlook for global bond markets has improved significantly since central banks in key markets began hiking interest rates in 2022. With interest rate cuts on the horizon in the euro area and the UK, bond investors stand to benefit if and when rates do come down as bond prices tend to move inversely to interest rate changes.

No one can predict when equity markets will fall, but we know that over time stock market investors will experience several peaks and troughs. That’s why we recommend long-term investors maintain an exposure to global bonds that aligns with their investment horizon and tolerance for risk.

Low-cost diversification with a multi-asset solution

Long-term investment success is rarely achieved by betting on winning stocks or the best-performing markets from year to year. Even when the opportunity seems certain, like the integration of AI into the global economy, long-term investors tend to be best served with a well-diversified multi-asset portfolio that doesn't make tactical bets based on the latest trends.

Globally diversified multi-asset funds and model portfolios can provide exposure to the best-performing sectors and individual securities without taking excessive risk. At the same time, building a global portfolio of equities and bonds can be costly. Our research has shown low-cost funds and model portfolios have a higher probability of performing better than costlier ones³. 

That’s why Vanguard’s multi-asset funds and model portfolios, whether index or active, strive to deliver broad market diversification at a low cost, providing our investors with a level of portfolio diversification that would be much more expensive to achieve by investing in individual funds themselves, given the costs involved.

¹ Source: Vanguard calculations based on data from Robert Shiller’s website, the US Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv and Global Financial Data. As at 1 January 2024.

² Source: Bloomberg. Notes: Analysis of monthly global equity and global bond market total returns in USD from 1 January 1990 to 30 April 2023. Global equities are represented by the MSCI ACWI Index. Global bonds are represented by the Bloomberg Global Aggregate Index Value (USD Hedged). An equity market downturn is defined as a decrease of more than 10% from the previous maximum.

³ Source: Morningstar and Vanguard. In a 2010 analysis across the universe of funds, researchers found that, regardless of fund type, low expense ratios were the best predictors of future relative outperformance (Kinnel, 2010).