Analysis-Lofty US stock market valuations bank on earnings strength

Yahoo

17-07-2025

By Lewis Krauskopf
NEW YORK (Reuters) -With Wall Street's surge to record highs, the U.S. stock market looks nearly as expensive as ever, and investors are debating whether the lofty valuations are a bearish signal or justified by the technology-heavy market's profit outlook.
Few investors would argue the broad stock market is cheap. Since late last month, the benchmark S&P 500 has traded above 22 times its expected earnings over the next year, according to LSEG Datastream. That's a price-to-earnings level the index has ascended to only about 7% of the time over the past 40 years.
Determining appropriate market valuations could help investors understand how expensive stocks could get or how deeply they might fall, especially if there are renewed recession concerns.
Whether current valuations are an imminent sell signal remains to be seen. Investors say the U.S. stock market can trade at elevated levels for an extended period of time.
Some investors believe a number of structural changes could justify higher stock valuations, including greater representation in indexes from tech companies that generate massive profits.
"By pretty much every historical metric (the market's valuation) is rich," said Keith Lerner, co-chief investment officer at Truist Advisory Services. "The question investors are grappling with is, is it warranted?"
The S&P 500 has soared 25% since April, as investors grew less fearful that President Donald Trump's "Liberation Day" tariffs would cause a recession. The index has gained 6% so far in 2025, and over 60% in the past three years.
As of Tuesday, the S&P 500's forward P/E ratio was 22.2, according to LSEG Datastream. That level is over 40% above the index's 40-year average of 15.8 and about 20% above its 10-year average of 18.6.
A metric comparing price to expected sales shows the S&P 500 trading over 60% above its average of the past 20 years, according to Datastream.
"On the broadest basis, the market has clearly got a valuation headwind relative to where it has been in history," said Patrick Ryan, chief investment strategist at Madison Investments.
Investors debate the relevance of historical comparisons. The bigger presence in indexes of technology and tech-related companies, which tend to carry higher valuations, drives up the P/E ratio, while the profit strength of the largest companies also means the index could deserve higher valuations, investors said.
The S&P 500's operating profit margin stood at 12% at the end of 2024, up from 9% in 2014, according to S&P Dow Jones Indices.
Other potential justifications for higher valuations include regular buying of equities from 401(k) and other retirement plans, and lower fees for index funds easing access to stocks.
While studies show elevated valuations suggest diminished returns over the longer term, they are not always the best "timing tools" for determining the market's near-term direction, said Ed Clissold, chief U.S. strategist at Ned Davis Research.
Still, Clissold said, "a lot of good news is priced into stocks at these levels."
In the April swoon, the S&P 500's P/E ratio sank to 17.9; in 2022's bear-market drop, driven by spiking interest rates, the P/E fell as low as 15.3.
Indeed, investors are wary that current valuations make stocks particularly susceptible to disappointments. One worry: Washington could fail to strike deals with trading partners ahead of August 1, when higher U.S. levies on numerous countries are set to start.
Another shock could be the early departure of Federal Reserve Chair Jerome Powell, whom Trump has persistently pressured to leave.
Corporate results also pose a test. Second-quarter reports are kicking off with S&P 500 earnings expected to have increased 6.5% from the year-earlier period, according to LSEG IBES.
Wall Street increasingly is focused on next year's profit potential, with S&P 500 earnings expected to rise 14% in 2026.
"Investors seem somewhat convinced that the S&P is going to generate about 10% earnings growth for a few years after this year," said David Bianco, Americas chief investment officer at DWS Group. "The equity market has become fairly dismissive of any kind of significant recession risk."
Some investors say that if artificial intelligence adoption broadly benefits the economy, "then maybe the valuations would be justified because the earnings growth the next few years could be substantial," Clissold said.
To be sure, some investors are investing more in relatively cheaper areas such as small caps and international stocks.
Ryan and others point to higher yields on U.S. government bonds, seen as risk-free if held to term, as one factor dimming the allure of stocks. The benchmark 10-year yield is around 4.5%, well above its level for much of the past 15 years.
"There are alternatives out there for you to move your capital to," Ryan said.
Scott Wren, senior global market strategist at Wells Fargo Investment Institute, said the firm is recommending clients trim equities in areas including industrials and consumer discretionary sectors, expecting broadly slowing earnings growth in coming months before accelerating. The firm has a year-end S&P 500 target of 6,000, about 4% below current levels.
"Valuation-wise, stocks are pretty lofty," Wren said. Still, he added, determining a fair valuation is trickier than it has been.
"Where is the line in the sand between expensive and not expensive?" Wren said. "It's harder to determine that."