LONDON—Despite heightened geopolitical tensions and growing economic uncertainty, US equity markets continue to reach new highs while defying historic valuation norms. At 41.97, the Shiller cyclically adjusted price-to-earnings (CAPE) ratio is near its record highest and well above its long-run median of roughly 16.
At the same time, the Buffett Indicator—the ratio of total US stock-market capitalization to GDP, widely regarded as a barometer of overall market valuation—is flashing red. A ratio of 75–90% is generally considered reasonable, while readings above 120% suggest the market is significantly overvalued. It currently stands at more than 230%
While sophisticated investors may not rely directly on these metrics, indicators like these nonetheless fuel growing concerns that financial markets have entered bubble territory. And elevated valuations are only part of the story: a range of debt indicators suggests that leverage across the financial system could have economic repercussions that have yet to be fully appreciated.
Current estimates, for example, suggest that the US stock-market rally is being fueled by more than $1 trillion in borrowed money. According to the Financial Industry Regulatory Authority (FINRA), US margin debt—the money investors borrow from brokerages to buy securities—rose by 54% over the past year, to a record $1.4 trillion. This leverage buildup is comparable in size to each major category of US consumer debt, including auto loans, student loans, and credit-card debt, leaving an already heavily indebted economy increasingly vulnerable to a severe market correction.
Alarmingly, many investors in leveraged exchange-traded funds (ETFs) may not fully understand that these products’ daily rebalancing effectively leaves them with significant short-volatility exposure. In other words, they are implicitly betting that market volatility will remain low or even decline.
Should markets experience sharp price swings, however, leveraged-ETF investors could suffer heavy losses, forcing funds to rebalance in ways that amplify selling pressures. Leveraged ETFs could therefore exacerbate market instability in the event of a broader sell-off.
Private credit represents another major source of vulnerability. Outside the traditional banking system, a modern variant of what John Kenneth Galbraith called the “bezzle“—undetected fraud within the financial system—may be steadily expanding. Since much of the private-credit market remains outside the purview of regulators, the true scale of leverage and the associated risks are difficult to assess.
As a result, it is impossible to determine whether sufficient capital has been set aside to absorb losses stemming from growing leverage outside the traditional banking system. In his 2025 letter to shareholders, JPMorgan CEO Jamie Dimon noted that non-bank institutions now account for 64% of leveraged lending, up from 54% in 2010. Their share of mortgage originations has risen from just 9% to 77% over the same period.
As governments—including those of the United States, the United Kingdom, and Japan—increasingly rely on shorter-term financing, risks are mounting in fixed-income markets as well. In the US, roughly 20% of outstanding federal debt consists of short-maturity Treasury bills. Although this strategy reduces borrowing costs in the short run, it also exposes governments to greater refinancing risk if interest rates remain elevated or rise further.
Meanwhile, pension funds and insurers have reduced their purchases of long-term government bonds, with hedge funds taking their place. Because hedge funds tend to trade their positions more actively, this shift could fuel market volatility.
At least two developments could trigger a sharp market correction, with potentially damaging spillovers into the real economy. The first is a rise in interest rates. Although inflationary pressures stemming from the Iran war appear to have eased, considerable uncertainty remains over whether the interim US-Iran ceasefire and ongoing negotiations will ensure the uninterrupted flow of energy supplies through the Strait of Hormuz.
More fundamentally, the recent decline in oil and other commodity prices may not be enough to bring inflation under control. Notably, Minneapolis Federal Reserve President Neel Kashkari recently said he expects one additional interest-rate increase this year, citing inflationary pressures beyond oil and gas.
The second potential trigger is the concentration of risk in US equity markets. Given that expectations for US investment, economic growth, and equity valuations are increasingly tied to AI, disappointing quarterly earnings or guidance from a major AI company could spark a market-wide sell-off. The fact that Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia, and Tesla—the so-called “Magnificent Seven”—now account for nearly one-third of the S&P 500’s total market capitalization has created a financial-market vulnerability.
To be sure, the Magnificent Seven alone are expected to spend $725 billion on capital expenditures in 2026, primarily on data centers and AI infrastructure—equivalent to more than 2% of US GDP. But while this investment drive is likely to boost US growth, it also carries significant downside risks. Should these plans be scaled back—or should AI fail to deliver the productivity gains investors expect—the resulting shock could be difficult to contain.
Copyright: Project Syndicate, 2026.
