The Stock Market Just Did Something For the 3rd Time in Over 100 Years. If History Is Any Guide, Prepare For This to Come Next.

Earnings per share (EPS) for the S&P 500 grew at 52% year over year in second-quarter 2026, according to FactSet estimates -- one of the fastest rates of growth in market history. It is also unsustainable.

Big tech companies are benefiting from reported earnings gains from artificial intelligence (AI), which are dragging down free cash flow, while also marking up stakes in start-ups and recent IPOs like SpaceX, which is inflating S&P 500 earnings power.

The market now trades at a forward price-to-earnings ratio (P/E) under 20, which does not look unreasonable. However, if you take a more comprehensive look at the cyclically adjusted P/E ratio (CAPE), this stock market has done something that has only happened twice before.

History suggests that trouble happens next.

One long bull market since 2009

The cyclically adjusted P/E ratio, otherwise known as the CAPE ratio, takes the current price of the S&P 500 index and divides it by the average earnings power of the index over the last 10 years. It does this to smooth out the bumps in earnings from any one year, such as 2026, when earnings power may be temporarily inflated.

The CAPE ratio has been above 30 for most of the last 10 years, and recently hit a new high above 41. The only other time in history the CAPE ratio was above 40 was the dot-com bubble in 1999. The only other time it was above 30? 1929, the peak of the bull market before the onset of the Great Depression.

A small data set is not going to be statistically relevant, and the stock market is a highly complex system, but I think it should be a flashing alarm to investors that the only other times in history that the CAPE ratio went above 30 were eventually followed by a collapse in stock prices.

Image source: Getty Images.

Are AI stocks in a bubble?

This historical evidence should raise the question of whether AI stocks are now in a bubble. It certainly feels frothy, with trillions of dollars in stock market value centered on AI stocks and AI supply chain stocks, such as semiconductors.

AI stocks exhibit characteristics similar to booms and busts in the history of the United States, such as those of railroads, electricity, automobiles, and radios. It didn't matter that the internet changed our lives, but when you price in growth decades before the fundamentals catch up, your share prices are in a precarious spot.

No investor should boldly predict that a stock market crash will happen tomorrow. Nothing in markets is 100% certain. It's possible that the CAPE ratio will keep climbing before the eventual fall, or that the productivity gains from AI will make the tens of trillions in stock market gains worthwhile from an earnings perspective. However, any investor needs to understand the possibility that AI stocks are in a bubble. It doesn't matter how much you use ChatGPT.

S&P 500 Shiller CAPE Ratio data by YCharts.

How to properly position your portfolio

So, what is an investor to do? First, if you are heavily positioned in AI stocks, now might be the time to diversify (especially if you are trading on margin). This does not mean you need to immediately dump all your AI stocks. A lot of these are high-quality businesses that may perform well over the long term, even if it is possible they'll fall 80% in a stock market crash.

Diversification is key for anyone looking to generate strong returns in the stock market through the cycle. With the CAPE ratio near an all-time high, smart investors should look to add stocks from different sectors to their portfolios, as well as some fixed income like Treasury bonds that will help them generate strong performance through any booms and busts.

Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.