The artificial intelligence-driven stock market rally may be entering its final stage, according to a new assessment from Capital Economics.
The Wall Street firm has therefore warned that the surge in AI-related equities is showing signs of excessive optimism despite further near-term upside potential.
The research firm expects the S&P 500 to continue benefiting from strong AI-related earnings momentum through the rest of 2026, with the benchmark index projected to reach 8,250 by year-end.
However, Capital Economics believes the gains are becoming increasingly disconnected from underlying fundamentals and forecasts the index will retreat to about 6,500 by the end of 2027.
“We think the AI rally is approaching its last stage but is probably not quite over yet. Accordingly, we expect the tech-heavy equity markets, such as those in the US, Korea, and Taiwan, to continue to outperform over the remainder of this year. But we expect them to fall, in some cases quite sharply, next year. Our baseline scenario is that the S&P 500 ends 2026 at 8,250 but drops back to 6,500 by the end of 2027,” the firm said.
The firm’s caution centers on valuation levels that have climbed sharply since the AI boom began in early 2023.
Capital Economics noted that the cyclically adjusted price-to-earnings (CAPE) ratio has risen by more than 12 points during that period and now stands above 40, a level last seen before the collapse of the dot-com bubble.
According to the analysts, valuation expansion has been responsible for most of the S&P 500’s gains over the past three years.
While traditional forward price-to-earnings metrics appear less stretched, the firm argues that longer-term valuation measures present a more concerning picture.
Tech stocks concentration
The warning comes as a small group of technology and semiconductor companies continues to account for a significant share of the market’s advance, increasing concentration risk across U.S. equities.
Beyond elevated valuations, Capital Economics questioned whether the exceptional earnings growth supporting AI stocks can continue indefinitely.
The firm highlighted rising technology-related capital spending relative to economic output and a near-record ratio of stock market value to the net worth of non-financial corporations as additional signs of overheating.
These indicators suggest the market could be experiencing a late-stage rally in which prices move further ahead of fundamentals before eventually correcting.
Although Capital Economics is not predicting an immediate downturn, it warned that weaker-than-expected revenue growth or a reassessment of AI spending assumptions could quickly undermine investor sentiment.
The analysts previously estimated that if the S&P 500 reaches around 8,000 by the end of 2026, a subsequent decline of at least 30% could become increasingly likely.
While such a correction would be significant, it would still fall short of the nearly 50% decline experienced following the Dot-com crash.
Capital Economics also pointed to other factors that could amplify downside risks, including strong foreign inflows into U.S. equities and a potential increase in share supply through major initial public offerings and secondary stock sales by large technology companies.
The firm noted that the concentration of market value in a narrow group of AI beneficiaries now exceeds the technology sector’s weighting during the peak of the late-1990s bubble, making the market more exposed to a reversal in sentiment.
Featured image via Shutterstock.
Be the first to comment