Vanguard economist: Can AI boom justify high stock valuations?

Key points

• AI spending is massive, but is it enough to significantly impact economic growth next year?

• Vanguard economist said would take a 40% increase in corporate profits in 2025 to justify the market's high valuation.

• What should investors expect and how should they prepare?

Joe Davis, the global chief economist at Vanguard, examines the impact of AI on the overvalued stock market.

Artificial intelligence, or AI, has driven the price of stocks higher, particularly over the past two years, as AI stocks like NVIDIA (NASDAQ: NVDA) and Broadcom (NASDAQ: AVGO) have seen their prices double and triple in recent years.  

But they have also contributed significantly to a stock market that is overvalued. The 10-year, inflation adjusted Shiller P/E ratio is at its highest level, 36, since July 2021, when it was at 38. The only other time in recent history where the Shiller P/E ratio has been that high is in late 1999. On both occasions, the markets crashed shortly thereafter.

In a recent report, Joe Davis, the global chief economist at investment management company Vanguard, analyzed why the fervor over AI and growth stocks has led to an overheated stock market.

AI is the future, but economic payoff not here yet

In his commentary, titled “Economic payoff of AI is coming—but it’s not here yet,” Davis seeks to “connect the dots” between high share prices, a potential economic slowdown, and the long-term promise of AI.

“I’m optimistic about the long-term potential of artificial intelligence (AI) to power big increases in worker productivity and economic growth,” Davis wrote. “But I’m pessimistic that AI can justify lofty equity valuations or save us from an economic soft patch this year or next.

Davis said it would take about $1 trillion in corporate spending on AI in 2025 to boost economic growth over 2% in the U.S. and that’s not likely. Instead, Davis and his team anticipate roughly $121 billion in AI spending next year, and even if it exceeds that amount by double, it is still well short of the $1 trillion needed and that some analysts have projected.

“Those would be tremendous outlays, to be sure,” Davis said. “Perhaps unprecedented. But $1 trillion in AI investment by 2025 would require 286% growth. That’s probably not going to happen, which means we’re unlikely to experience an AI-driven economic boom in 2025.”

The $1 trillion in AI spending is likely coming, Davis added, just not in the next year or so.

Corporate earnings would need to rise 40% to offset stock price growth

So, what does this mean for stocks? As Davis explained it, the enthusiasm for AI stocks does not align with the economic and corporate earnings growth that is needed to correct the high valuation of the U.S. stock market. 

“We wondered how fast profits would have to grow to unwind the excess in the U.S. stock market. Assuming a three-year horizon for a return to fair value, the answer is about 40% per year,” Davis wrote.

To put that in perspective, corporate earnings have averaged 4% annual growth since 1871, but in more recent history, they averaged 21% in the 1920s with the dawn of electricity, 15% in the 1990s during the PC and Internet boom, and 13% since 2020 in the COVID-19/AI era. Certainly, 40% growth would be twice the rate of anything we have seen in the past 100 years.

And considering the likelihood of an economic slowdown in 2025, it seems unlikely, to say the least. Davis and his team project economic growth to be 1% to 1.5% in 2025, which is roughly on par with what most economists forecast. It would also be lower than the roughly 2% growth anticipated for 2024.

Diversify with value and small-cap stocks and ETFs

“Investors looking to connect the dots between the current level of share prices, probable levels of economic activity, and the widespread enthusiasm for AI would be well-advised to temper any expectations that economic growth and corporate profits are set for near-term acceleration,” Davis concluded.

Instead, investors should also be prepared for periodic corrections among overpriced AI and growth stocks that move prices closer to their fair values. 

In other words, keep an eye on those P/E ratios to make sure they are not significantly higher than their normal ranges.

Investors should also seek to diversify their portfolios with value stocks and ETFs, small-caps, as well as international investments, most of which are not overvalued.