Capital Economics warns Wall Street may be in a ‘late-stage bubble’
Strong valuations, stretched AI expectations and rising market concentration are raising concerns that the US equity rally may be approaching a more fragile stage
Wall Street’s powerful rally is showing several characteristics that have historically appeared near major market peaks, according to Capital Economics senior markets economist James Reilly. While he expects the S&P 500 to continue rising and potentially push the current rally further this year, he believes the market increasingly resembles a “late-stage bubble” that could face a sharper correction next year.
One of the clearest concerns is valuation. Reilly points to the S&P 500’s cyclically adjusted price-to-earnings ratio, which has moved close to levels seen during the dotcom boom. The valuation gap between US equities and government bonds is also unusually stretched, suggesting investors are paying a significant premium for exposure to shares. This leaves the market more vulnerable if earnings or economic expectations fail to justify current prices.
AI optimism adds to the pressure
Artificial intelligence has become one of the biggest drivers of the current market advance, but Capital Economics believes expectations surrounding AI-related earnings have become exceptionally high. Reilly acknowledges that AI could improve productivity and support stronger corporate earnings, but argues that the gains currently being priced into some companies may be too optimistic.
The concern becomes more significant because of the heavy influence of major technology companies on the broader index. The S&P 500’s largest companies now account for an unusually large share of the index, meaning disappointing results from a handful of major AI-related firms could have an outsized impact on the overall market.
Rising debt and weaker cash flow raise another warning
Capital Economics is also watching the financial demands of the AI investment boom. The major technology companies driving the expansion are committing enormous amounts of capital to data centres and other infrastructure, while their combined free cash flow is expected to turn negative in 2027, according to Reilly.
At the same time, corporate debt issuance has climbed to record levels, with borrowing by major AI hyperscalers more than doubling from the previous year. This combination of heavy investment, rising borrowing and increasingly demanding earnings expectations could create additional pressure if the expected returns from AI spending take longer to materialise.
Market concentration and investor behaviour add to bubble risks
Reilly also highlights increasing volatility in AI-sensitive markets, record levels of market concentration and a rise in US equity issuance. More major IPOs and share sales by AI companies could increase the supply of stocks available to investors, potentially creating additional pressure on valuations.
Foreign ownership of US equities has also reached record levels, while leverage used to finance share purchases continues to rise.
Taken together, Capital Economics identifies eight warning signs, ranging from elevated valuations and AI expectations to corporate borrowing, market concentration, equity issuance, foreign ownership and leverage. The firm’s view is not that the market must immediately reverse, but that the combination of these factors suggests Wall Street’s current rally may be much closer to its later stages than its beginning.
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