Investing.com -- The S&P 500's valuation remains deeply stretched when measured against long-run earnings trends, a signal that equity markets may be entering the final, euphoric phase of the artificial intelligence rally, according to Capital Economics.

John Higgins, Chief Economic Adviser at Capital Economics, warned in a note on Tuesday that the index's cyclically adjusted price-to-earnings ratio (known as the CAPE), has risen by more than 12 points since the start of 2023 to above 40, "a level last seen before the dotcom bubble burst."

The CAPE has accounted for just over two-thirds of the S&P 500's rally since early 2023, which Capital Economics broadly identifies as the starting point of the AI-driven advance.

Higgins said this is "one sign that we may be in the 'blow-off' phase of the AI-fuelled rally."

He added that the picture looks less alarming through a conventional lens. The forward 12-month price-to-earnings ratio has risen by fewer than four points and currently sits around 21, well below its dotcom-era peak above 24.

The forward three-year ratio has contributed only about 13% to the rally and stands near 17, compared to a dotcom peak above 22.

Capital Economics noted that it is inclined to weight the CAPE more heavily, citing skepticism that recent exceptional earnings-per-share growth is sustainable, elevated capital spending on technology relative to GDP, and a near-record ratio of equity market value to net worth in the U.S. nonfinancial corporate sector as its three concerns.

Higgins also noted that excess CAPE yield has historically been a reliable indicator of long-run equity returns relative to Treasuries, and the current reading points to below-average excess returns over the coming decade.