Are Investors Behaving Rationally?

ra·tio·nal (adj.) — based on or in accordance with reason or logic; not influenced by emotion.

I like to share the chart below when discussing the state of the current bull market.

At the end of 2025, the S&P 500’s 3-year annualized return was over 20%. This is a strong return that is not historically unprecedented, but it’s also not common and sits in the right tail of the distribution.

After experiencing these gains, it’s normal to question whether investors are behaving rationally and wonder how long the “good times” may last.

That being said, there’s a difference between “let’s not get complacent” and “the market is a bubble and investors are behaving irrationally.”

Despite what feels like a frothy set-up coming into the year, I think 2026 has shown that in many ways, investors are behaving quite rationally – with an important caveat at the end.

Let’s recap the last few years to understand how we got to this point in the bull market.

Mega-Caps Have Dominated the Headlines… For Good Reason

A large share of the S&P 500’s returns since 12/31/2022 have come from technology or technology-adjacent stocks that have the largest market capitalizations in the index. Yet these companies have also delivered tremendous earning growth alongside impressive stock price performance.

Looking at a group of “mega-cap” stocks (NVDA, AAPL, MSFT, AMZN, GOOGL, AVGO, META, TSLA, MU), their combined market capitalizations as a percentage of the S&P 500 have grown from ~20% of the index at the end of 2022 to now ~35% of the index. Over that same period, their aggregate GAAP net income as a percentage of the index has grown correspondingly, from just under ~20% to about ~32% of the index today.

Aggregate earnings grew 30.9% per year since the end of 2022 for this group of mega-cap stocks.

This looks like the market properly accounting for the tremendous share of earnings generated by the largest companies, not necessarily a bubble with no fundamental foundation.

Valuation Check-Up

Since the start of 2023, mega-cap relative valuation multiples have compressed from 2023 extremes, while the remaining premium has concentrated in perceived AI builders and beneficiaries like Broadcom (AVGO).

However, the companies investing operating cash flow into the purchase of semiconductor chips and data centers have seen their relative multiples remain steady or shrink (i.e. Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL) and Meta (META)).  

Again, this shows that market participants are behaving somewhat rationally.

Companies that are investing hundreds of billions into AI bets are trading in line with or at a discount to the broader market, even though their topline growth and GAAP earnings continue to grow at double-digit percentages.

Investors aren’t writing blank checks for stocks just because they have a horse in the AI race.

Operating Cash Flow Is Rising, But Free Cash Flow Conversion Is Falling

Valuation multiples only tell part of the story.

For the biggest spenders on data centers, capital expenditures are eating into what is otherwise strong growth in operating cash flows.

The top panel in the chart below shows the aggregate cash flow from operations for four companies (MSFT, AMZN, GOOGL, and META) in dark blue relative to the free cash flow available to shareholders after capital investments in light blue. For this group of mega-caps, cash flow from operations has increased by a combined $321 billion in the last 3.5 years, while free cash flow has only increased $89 billion.

That $232 billion gap shows up as a steady decline in free cash flow as a percentage of cash from operations for each company (the bottom panel of the chart).

Where are those capital expenditures going?

Lots of semiconductor chips. One company’s expenses are another company’s profits.

Since 2023, the combined GAAP net income for Nvidia, Broadcom, and Micron (semiconductor mega-caps) has exploded by $183 billion.

Billions of dollars are flowing from Microsoft, Amazon, Alphabet, and Meta (the “AI spenders”) to semiconductor companies like Nvidia, Broadcom, and Micron (the “AI builders”), and it shows in the price returns for 2026.

Year-to-date, the semiconductor index (“AI builders”) is up +34.7% as of June 26, 2026. The price returns for the “AI spenders” like MSFT, AMZN, GOOGL, and META are either flat or down in relative terms on the year. In fact, Microsoft and Meta are down double digits for the year despite strong earnings growth.

Market participants are scrutinizing capital spending, not ignoring it.

Concluding Thoughts

Today’s stock market levels would be much more concerning if investors were expressing no signs of skepticism about the amount of money being spent on data centers to train and run AI models.

Instead, we can see the stock market taking into consideration shifting capital allocation strategies for the largest stocks in the S&P 500.

The data shows a market that is, at least for now, doing what markets are supposed to do: pricing in earnings growth, penalizing capital-intensive bets, and rewarding actual results. That seems rational to me.

However, I would be remiss not to point out that my observation about investors behaving “rationally” in the present does not necessarily factor in the time horizon associated with various investment strategies.

While it may be appropriate for market participants to penalize the capital-intensive bets that a company like Microsoft is making today, long-term shareholders may be rewarded for their patience if the company is able to generate sustainable returns in the future on today’s investments.

As the author of Psychology of Money Morgan Housel likes to say: “A lot of financial debates are just people with different time horizons talking over each other.”

*AAPL, MSFT, and GOOGL are currently held in Peak’s Model Portfolio. The Model Portfolio is not a real cash portfolio. It represents the core direction of our portfolio management strategies. Individual client portfolios are managed in accordance with the clients’ specific objectives and constraints. Historical information is available upon request.

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