The Danger of a Stock Market Melt-Up

Market meltdowns have been a big worry lately, and for good reason. With President Trump imposing the highest tariffs since the Great Depression and enacting myriad other disruptive policies, the threat of another market crash can’t be ignored.

Yet despite an 18.9 percent downturn in the S&P 500 earlier this year, the stock market has rebounded. It has continually shrugged off shocks that, in previous years, may have set off a prolonged bear market.

In fact, stocks have become expensive again. While the potential for a serious market downturn hasn’t vanished, I think it’s also time to begin thinking about another problem: the danger of a market melt-up.

By many measures, we’re already in perilously overvalued territory. On a historical basis, share prices are high in relation to corporate earnings, assets and the size of the overall economy.

I don’t want to go too far with this. The U.S. stock market isn’t nearly as expensive as it was at the height of the dot-com bubble in the late 1990s and early 2000. But it is increasingly pricey — surprisingly so, when you consider the repeated blows to market sentiment dealt by the Trump administration.

Tariffs re-emerged as a major issue over the past week. The administration issued an array of announcements: Tariffs will increase, be delayed, not be delayed, be imposed on copper, be negotiated lower, be made permanent, and on and on. Who really knows? The stock market has been absorbing this information, stumbling from time to time but then regaining its footing. While the economic impact of the tariffs has barely been felt yet, the stock market remains much higher than it was at the beginning of the year.

How High?

One sign that the “market is a little out over its skis,” as Bespoke Investment Group put it in a note to clients this past week, is that shares of companies that are making no profit have been rising faster than those that are deeply profitable. Bespoke, an independent financial research firm, said, “For stocks that are losing money, generally speaking, the bigger the losses the better the returns.”

Companies with marvelous narratives about future returns are capturing investors’ imaginations. For example, a leading stock in the Russell 3000 index, with a gain of more than 500 percent this year, was Aeva Technologies. It makes sensors for robots, autonomous vehicles and drones — all hot items these days. Yet the company is losing a ton of money.

No matter. In the current market, the sky is the limit. Referring to the astonishing stock performance of money-losing companies, Bespoke said: “This is, to put it mildly, an unsustainable dynamic. Valuations can only do so much to support markets before the trend reverses. Of course, there are other sources of market return other than multiple expansion of no-earnings companies, but this dynamic is still emblematic of a market that is starting to get carried away with itself.”

Moneymaking companies are receiving remarkably high valuations, too. Take Nvidia, which this past week became the first company to pierce the $4 trillion threshold for stock market capitalization. Nvidia is highly profitable, and it designs many of the advanced chips that power artificial intelligence Nothing seems to be more prized than A.I. in the market right now.

Nvidia stock is extremely expensive: Its price-to-earnings ratio is above 50:1, according to FactSet. That means that an investor must pay more than $50 for every $1 of the company’s earnings. Compared with the start of 2023, when its price was 250 times its earnings, the company may look like a bargain. Even so, its current valuation implies that its profits will grow at lightning speed for decades to come. The market may be comfortable with that assumption, but the law of gravity makes me question whether Nvidia’s price is sustainable.

Booms and Busts

Steep market valuations alone don’t cause price declines, but in the past, they have eventually led to trouble. Alan Greenspan, the former Federal Reserve chairman, warned elliptically of excessively high stock prices in December 1996, when he famously asked, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”

He didn’t provide a clear answer. In response to Mr. Greenspan’s words, the market foundered but then shot up further. It wasn’t until March 2000 that stock prices — by then wildly exorbitant by most measures — ultimately crashed.

Irrational exuberance has become standard Wall Street jargon. Robert Shiller, the Yale economist and Nobel laureate, used the phrase as the title for an important book.

Melt-up isn’t as widely used, but it may be on the verge of becoming so.

“The melt-up in risk assets continues,” HSBC, the global bank based in London, warned recently.

It saw two distinct possibilities: an intensifying melt-up reflecting investor exuberance or a meltdown in the face of what could turn out to be endlessly troubling developments, many of them meted out by the Trump administration.

“The bearish narrative can point to tariff rates,” the bank wrote. But, HSBC also said, Wall Street analysts have lowered expectations for corporate earnings to a level that most companies are likely to exceed. Therefore, it concluded, “We have the perfect recipe for the broad-based melt-up in risk assets to continue.”

Melt-ups have long been part of the vocabulary of Edward Yardeni, the independent Wall Street economist and strategist. At the moment, he said, the market is “sort of, kind of, in a melt-up.”

Referring to the sharp stock downturn earlier this year, he added, “Just look at the way this correction has been reversed, it’s been a melt-up.” Stock valuations are “pretty rich,” he said, and people in the markets are “back to believing” that artificial intelligence is “a miracle technology.”

In an email, he estimated a range of “subjective probabilities” for the stock market. There is a 60 percent chance that the bull market will continue, he said, a 25 percent chance of a bear market caused by a recession, and a third possibility: a 15 percent chance of a melt-up.

In a melt-up, stocks would spiral much higher, generating big gains on an unstable base.

The gains would be wonderful. But any provocation or disruption could set off a severe downturn.

Don’t Get Too Excited

“Markets can remain irrational longer than you can remain solvent.” That’s an adage often attributed to the British economist John Maynard Keynes, though I’ve never found proof that he said it. Nevertheless, it’s apt. I worry about market melt-ups but rarely feel confident enough about my observations to do anything about it in my investing life.

Only occasionally, in my view, is it completely obvious that the market is so high that it must fall, or so low that it must rise. (Such moments are usually accompanied by a major shift in policy by the Federal Reserve — lowering interest rates sharply at the bottom of a bear market, or raising them when the economy is so red hot that it is on the verge of burning.) This isn’t one of those times. In the second Trump administration, anything is possible for the stock market. It could rise, fall or, more likely, be extremely volatile and vacillate between extremes.

As a long-term investor using mainly diversified global index funds, I try to ride out the market’s madness, using bonds and cash (much of it in money-market funds) to buffer me from severe stock downturns. I’ve bulked up that buffer this year.

While I take a long-term view, I would prefer a calmer ride. Who needs the agony of a stock market decline, even if you don’t intend to touch the money for decades? More important, many people — including those in retirement or planning to start it soon — can’t handle major downturns. And market crashes are often associated with recessions.

Melt-ups are much more pleasant than downturns but they cause major problems, too, because they are often followed by crashes.

If would be far better if markets were calm and orderly. So I’m hoping we have neither a melt-up nor a meltdown now. A traditionally bumpy market, with setbacks but an upward arc, is in nearly everyone’s interest. So don’t get too excited if markets start to fly toward the sky.