The velocity of the S&P 500 Index’s 35% rally from the April lows has taken many investors by surprise, including us. Nearly all traditional valuation metrics suggest the market is expensive: the forward (next-12-month) P/E recently stood at 22.8x, a level previously only witnessed during the tech bubble of the late 1990s. While some signs of froth are certainly evident, other factors suggest the market’s recent advance is grounded in a favorable policy mix that supports improving fundamentals, or perhaps even a boom, into 2026. As a result, whether a bubble is forming has become a key debate for equity investors.
One example of a decoupling between stock prices and underlying fundamentals that bears watching is recent labor market weakness, the argument being that slowing job creation is a sign that the economy is on shaky footing. By extension, equities should be lower as reduced labor income weighs on overall consumer spending.
However, job creation remains in positive territory and is expected to rebound into 2026 as fiscal stimulus from the One Big Beautiful Bill (OBBB) comes online and trade/immigration policy headwinds abate. Importantly, the index of Aggregate Weekly Payrolls — a good proxy for overall U.S. labor income — continues to show solid gains and has expanded at a 4.2% annualized pace through the first eight months of the year, which should power future consumption. Furthermore, with uncertainty waning and hiring expected to rebound, it would not be a surprise to see this metric accelerate toward 2024’s 4.6% pace in the coming months.
Another area where fundamentals are not suggestive of bubble territory is corporate profits. Earnings picked up in the second quarter, and forward guidance from companies suggests that they are finding ways to offset the costs from higher tariffs with margins and profits expected to continue to rise in the third quarter and into 2026. Accelerating earnings are a harbinger of a healthy labor market, whereas they tend to plateau and then decline beginning two quarters on average ahead of historical recessions dating back to 1965. With the consensus expecting continued profit growth in the year to come, the recent trajectory also bears little resemblance to these past periods.
Many of the disconnects between rising equities and underlying fundamentals that the bubble camp highlights are more nuanced than they initially appear. This begs the question if, instead of a bubble, is a boom on the horizon? The fiscal and monetary policy backdrops are more suggestive of a boom, with the potent policy mix of a Fed cutting cycle and a fiscal stimulus package. This combination is typically only seen in the wake of economic downturns in an effort to lift the economy out of the doldrums.
Although the Fed may ultimately under-deliver on the expectations of an additional four-plus cuts priced into futures markets by the end of 2026, we believe that multiple cuts will occur. If the Fed ultimately ends up cutting less than the market expects, we believe this would be treated as a positive by investors given it would likely come amid a healthier economic backdrop. With the passage of the OBBB, the boost from fiscal policy is more certain than the Fed’s path in 2026. Fiscal stimulus in the form of consumer and corporate tax cuts will arrive in 2026, with the Congressional Budget Office estimating the impact at nearly 1% of GDP.
The improved outlook for 2026 is not just a function of government policy, however. Economists expect consumer spending to remain robust while business investment accelerates on the back of continued strength in artificial intelligence (AI) infrastructure. Already, some investors point to hundreds of billions of dollars in infrastructure capex (chips, power, data centers) and sky-high pay packages for leading AI researchers as signs of irrational exuberance reminiscent of the late 1990s tech bubble.
However, it is important to note that while equities did form a bubble during this period, the underlying economy also saw benefits. With the benefit of hindsight, this is clear in productivity data from the Internet revolution. The key question at present is whether strong productivity gains can be sustained and move higher in a similar fashion.
A common adage is that “the stock market is not the economy.” The two are closely related but can disconnect at times and in certain areas. As of late this rings most true with regard to AI, with signs of froth evident in some areas of the equity market. One example is the 52% advance in the Goldman Sachs “Non-Profitable Tech” index year to date through September, where investors are placing significant emphasis on potential earnings of these companies.
However, many of the current tech leaders that have powered the index higher in recent years are delivering strong profits and free cash flow. While investors are assigning lofty multiples to the potential leaders of tomorrow, the sector still trades materially below the multiples seen during the peak of the tech bubble while delivering superior (50% better) returns on equity.
There is no guarantee that the current tech-driven bull market will reach the size of previous bubbles before encountering problems or collapsing. However, this reminds us of another time-tested market adage, “Bull markets don’t die of old age, they’re killed by the Federal Reserve.” With that in mind, if a bubble is indeed forming, we could be witnessing its early days because the Fed is working to support the economy and financial markets, not slow their ascent.
The Fed began to cut rates last month. Historically, equities have fared well in the year after the Fed began a soft landing rate cut cycle, rising 18.3% on average over the next year and 48.6% over the next two. If sell-side consensus expectations of 12.9% EPS growth over the next 12 months are realized, it would be consistent with a soft landing as one-year forward earnings historically decline double digits on average in recessionary outcomes.
Although strong gains on the back of rate cuts would seem to play into the bubble narrative, one key bubble ingredient that we believe remains missing is speculative excess. Although signs of froth exist, classic bubbles typically see rapid price acceleration driven by investor euphoria, indiscriminate buying and a detachment from financial realities.
At present, investor sentiment remains cautious with the number of bullish and bearish respondents to the AAII Sentiment Survey being nearly balanced (+3.7 bullish, a mid-pack reading). Widespread indiscriminate buying does not appear to be playing out and the rally in equities has coincided with an improving fundamental outlook, which suggests a lack of detachment from financial reality. To that end, economist expectations for 2026 GDP have risen by 40 bps from the mid-May lows, while sell-side EPS expectations for the S&P 500 took an unusual turn higher during the third quarter following passage of the OBBB and as trade policy visibility improved.
Historically, bubbles have formed when overly ample liquidity has encouraged excessive risk-taking behavior. While liquidity is certainly ample at present, excessive risk-taking behavior does not appear to be playing out. This is not to say that signs of excess do not exist nor that pockets of weakness aren’t apparent. However, these remain somewhat isolated or are explainable, such as reduced immigration being a primary contributor to slower job creation.
Over the long run, changes in earnings expectations explain the vast majority — about two-thirds over one-year periods and three-quarters over two-year periods — of stock price movement. Only time will tell if equities are currently discounting an overly optimistic “bubbly” future or an underappreciated “boom” in earnings, but the broadly improving outlook leads us to believe that the boom scenario is more likely.
Jeffrey Schulze, CFA, is Director, Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.