Why High Valuations May Not Matter

(And Where to Look for Opportunities in 2025)

By: Michael W Arone, CFA, Chief Investment Strategist

The S&P 500® Index trades at more than 24 times next year’s forward earnings. That price-to-earnings multiple is notably higher than both the 5-year and 10-year averages.¹ After two outstanding years of stock market performance, it’s no surprise that investors are worried about high valuations headed into 2025.

In fact, nearly all measures of market valuation — price-to-sales, price-to-book, the Fed model, CAPE, and the Buffett Indicator — suggest that the S&P 500 is historically expensive.

Long-term investors would always rather purchase stocks in a valuation valley instead of a potential valuation peak. Regrettably, for investors looking to put capital to work in the current environment, S&P 500 stocks are pricey.

Three Points to Consider About Valuations

As investors look to 2025 worried about the S&P 500’s current high valuations, they should consider:

1) Valuations are a poor predictor of short-term price performance. Valuations tell you very little about price performance over the next 12 months. Expensive investments can, and often do, get more expensive.

2) Current fundamentals support higher valuations. The four most dangerous words in investing are, “This time is different,” but today’s strong fundamentals may justify structurally higher valuations:

Earnings Growth: Investors are discounting a scenario where S&P 500 companies’ earnings will outpace the US economy by about 2.5% a year for the next 10 years. If they do, the ratio of earnings relative to GDP will grow from 7% today to 9% in 2035. For context, that number was at 4% at the end of the 1990s.  So, US companies’ earnings as a percentage of GDP are expanding at a solid rate.

The technology sector is critical to the forecast. Today, technology companies drive 30% of the S&P 500’s earnings growth, up from just 10% two decades ago.³ The S&P 500’s 24 times next year’s forward earnings multiple is largely dependent on technology companies continuing their earnings dominance — so far, the evidence supports that outcome.

Return on Equity: S&P 500 companies’ return on equity is about 20%. Free cash flow margins are 9.5% and S&P 500 companies return 3/4 of every dollar of earnings back to shareholders.⁴ These numbers don’t exist anywhere else in the world — not in Europe, Japan, or China.

Profit Margins: In this century, profit margins in the US have practically doubled, primarily driven by falling interest rates, lower taxes, globalization, and technology companies’ incredible growth. Looking toward next year, the Federal Reserve (Fed) is likely to continue to cut rates, corporate tax rates are likely to fall, and S&P 500 earnings, propelled by technology companies, are expected to grow by 15%.⁵ As a result, three of the four factors that have helped the US double profit margins this century remain favorable.

3) Valuations are not always what they appear to be. If we were to remove the Mag 7 from the S&P 500, the other 493 stocks taken together trade at 16 times forward earnings, in line with historical averages.⁶ The S&P SmallCap 600® Index is trading at 17 times forward earnings versus almost 25 times for the S&P 500. Regional banks are trading at 14 times forward earnings.⁷ Finally, in addition to small caps and banks trading at significant discounts relative to the market, the PEG ratio suggests investors could also find opportunities by taking a broader look at the fast growing technology industry.

Ride US Economic Tailwinds, one of the themes in our 2025 ETF Market Outlook, explores these attractive investment opportunities that trade at far lower multiples and have strong expected earnings growth that will likely benefit from the current environment.

Trading Valuation Worries for Investment Strategies

Some of the longest and strongest bull markets were born on dirt cheap valuations. And some of the worst bear markets began at the loftiest of stock market prices. So, investors are right to be worried about stretched market valuations, especially over a longer investment horizon. It’s the right question to ask in the current environment.

But valuations have never been a good predictor of short-term price changes. Today’s high valuations tell investors very little about what might happen next year. And strong fundamentals suggest that perhaps US stocks should trade at structurally higher valuations as a reward for delivering exceptional results to shareholders.

So, while there’s no need for investors to panic about the S&P 500’s current high valuations, allocating more capital to investments trading at more reasonable valuations — with stronger expected earnings growth that may benefit more acutely from anticipated policy changes next year — is prudent.

Originally posted on December 11, 2024 on SSGA blog

PHOTO CREDIT: https://www.shutterstock.com/g/78image

VIA SHUTTERSTOCK

FOOTNOTES:

¹ Earnings Insight, FactSet, December 5, 2024.

² Empirical Research Partners, September 3, 2024.

³ Empirical Research Partners, September 3, 2024.

⁴ Empirical Research Partners, September 27, 2024.

⁵ Bloomberg Finance, L.P., as of December 10, 2024.

⁶ Bloomberg Finance, L.P., as of December 10, 2024.

⁷ Bloomberg Finance, L.P., as of December 10, 2024.

DISCLOSURES:

The views expressed in this material are the views of Michael Arone through the period ended December 10, 2024, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

Past performance is not a reliable indicator of future performance.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
Investing involves risk including the risk of loss of principal.

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