ECB says a correction is likely whether or not today's prices are rational

Five economists at the European Central Bank published an analysis on Monday arguing that stock market valuations are likely to correct, and that the argument holds whether or not today’s prices are rational.

The post, by Malin Andersson, Johannes Breckenfelder, Stefano Corradin, Kalin Nikolov and Maria Antonietta Viola, puts US valuations close to their historical peak on the CAPE ratio, a measure comparing share prices against inflation-adjusted earnings averaged over the preceding decade.

Euro-area valuations have risen as well, by less. Research on past technological revolutions, the economists write, points to “a worrisome conclusion.”

The views are the authors’ own and do not necessarily represent the ECB.

Rational valuations and investor exuberance point to the same outcome

This post gives both the rational and behavioural explanation. According to the rational explanation, extreme uncertainty with regard to a new technology’s efficiency would be enough to justify the valuation of its stocks at very high levels since one loses nothing much by trying it out and there is no way to tell the limit on the upside. This asymmetry creates an option value which increases price-to-earnings ratios for early adopters.

Nvidia is used by the economists as an example where the rationale of investors has been that a firm will be the next Google. This theoretical framework is based on research conducted by Ľuboš Pástor and Pietro Veronesi in 2009.

Prices can still fall from there. While a technology sits in a few firms, failure is diversifiable. As adoption spreads, the same uncertainty becomes economy-wide and can no longer be diversified, so investors demand a higher risk premium. Profits need not fall for prices to. Adoption helps cash flows, but historically the rising premium prevails unless profit growth is strong enough to compensate.

The behavioral approach goes hand-in-hand: overconfident investors bid beyond fundamentals, and once that overconfidence diminishes, the market may crash even further. “The exact moment cannot be predicted in advance,” state the economists, and “these sequences can be identified only retrospectively.”

Euro-zone households have €440bn exposure to US tech sector

Most euro-area investments in the Magnificent Seven are via mutual funds and exchange traded funds, as opposed to being direct shareholdings. Households, increasingly channelling money into low-cost ETFs, carry around €440 billion of exposure to US technology equities without necessarily being aware of the concentration risk.

Insurance companies and pension funds hold significant positions too. The holdings data is measured as of the third quarter of 2025.

The fund structure is itself a transmission channel. A market correction can compel funds to liquidate in order to satisfy redemptions, starting with their most liquid holdings and finishing with their troubled assets, thereby driving prices down and causing further redemptions. This is why the economists consider the Mag7 market correction to be a matter of financial stability for the euro area.

“The real risk,” they say, “is not only the equity market correction but one that takes place in an environment where the authorities have much less room than normal to ease monetary and fiscal policies in order to alleviate the impact.”

Europe looks less stretched than 2000, but remains exposed to a US selloff

A home-grown crash looks less likely, the post argues. Euro-area price-to-earnings ratios remain considerably lower than US levels, productivity and markups in the information and communication technology sector are rising, and the business climate in euro-area digital services does not appear exuberant.

Firms’ AI adoption is rising notably a few years after ChatGPT launched in 2022, and digital investment across the region over the past decade grew more than three times the cumulative growth in GDP.

As Cryptopolitan reported in December, the ECB drew the dot-com comparison in its financial stability review then as well, and Morningstar chief equity strategist Michael Field noted that the Magnificent Seven accounted for 40% of the Morningstar US index.

The limiting factor for such protection, however, lies in correlation. US and euro-zone stock markets have traditionally moved in tandem, and the economists predict that an AI catastrophe in the US would not just remain a problem for the US.

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