Why High Valuations May Not Matter and Where to Look for Opportunities in 2025
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.
Get more insight for the year ahead in our 2025 ETF Market Outlook, Soft Landings and Bull Markets.