Are Valuations Too High?

Jim Denholm
3 days ago
10 min read

Following the tariff scare in the spring, markets have calmly but consistently pushed to new all-time highs. Some investors say that equity valuations are too high, and that we are due for a correction. What does the data say?

Equity markets are at or near all-time highs.

That is the most common feature of a bull market.

But when new highs are combined with a rate-cutting environment, mostly negative sentiment, and increasing earnings, we should err on the side of being bullish.

As always, volatility can increase any time, as today's 1.2% decline illustrates.

But for now this should be an opportunity to put cash to work instead of reducing risk in anticipation of a bigger bear market.

That said, now is not the time for complacency. The bull market has been strong, but we haven't seen a real, full-blown recession since 2009.

In this report, we will discuss:

A bull market doing bull market things
Valuations are not as important as you'd think
Earnings are important and they are strong (and accelerating)
Monetary Base and Stocks
WATCH THIS VIDEO: The Fed Explained (sort of)

A Bull Market doing Bull Market Things

Following the emotional selloff from the tariff scare in the spring, markets have calmly grinded back to new all-time highs.

In fact, we now have all of the following stock indexes reaching all-time highs in the past few weeks:

S&P 500
S&P 100
Nasdaq Composite
Nasdaq 100
Dow Jones Industrials
US Mid Caps
US Small Caps
Developed International Stocks
Emerging Markets Stocks
Gold
Silver
Bitcoin

That's a lot.

Does that mean there is more risk, or can it continue?

Let's look at the positives first:

All-time highs in price
All-time highs in earnings
Growth rates accelerating
Fed is cutting interest rates
Global peace and trade agreements everywhere
Investor sentiment is fearful rather than greedy
A transformative technology in AI that can revolutionize productivity

These factors are very bullish.

Given this backdrop, we should not be surprised if markets continue to grind higher, albeit with the occasional scary selloff mixed in.

Let's glance at the chart of the S&P 500 first.

The top section in our first chart shows the price of the S&P 500 index since February. After the lows were established in April, the market has been grinding higher with very limited volatility.

It sure hasn't felt that way though.

Part of the reason it feels more uncertain than what the data shows is that the move off the lows has been characterized by short, sharp selloffs, like what we are seeing now.

In fact, the largest selloff we've seen since May has been less than 5%.

Every dip is being bought. This is classic bull market behavior.

In fact, with buyers stepping in quickly and with authority, we would think that the market would be incredibly optimistic. Extreme optimism tends to accompany a market peaks.

The reason is simple: supply and demand drive stock prices.

When sentiment is highly optimistic, investors are usually all-in. They are rooting for their positions to gain value, as opposed to sitting on the sidelines waiting for prices to move lower.

Optimistic investors typically don't have dry powder to put to work.

Fearful investors do.

And when everyone is all-in, the market loses the incremental buyer.

Right now, we are seeing investors fearful of two opposite scenarios...fearful that something bad may happen, but also fearful of missing out on something good that may happen.

Shallow pullbacks show that investors are willing to buy even the slightest breaks in the uptrend.

But sentiment surveys, such as the CNN Fear and Greed Index below, tell a story of a fearful investor.

Essentially, investors are saying they are scared but their behavior is showing they are not.

The bottom part of the chart shows the performance after the Fear & Greed Index was in Extreme Fear (less than 25) within 2% of an all-time high.

The data shows that over the two months following this signal, volatility has been limited.

The largest pullback was -8.4% two months later. Not exactly worrisome, as the market has 10% pullbacks every 12-18 months on average.

There are risks, as always. The big ones we are hearing now:

Valuations are too high
Earnings don't justify the move higher
Politics are a mess
AI is in a bubble like internet stocks in the late 1990's

These are valid concerns, so let's analyze them.

Valuations Too High?

Something we are starting to hear rumblings about are valuations.

Currently they are high relative to history, based on multiple methodologies.

Based on one measurement, equity value versus GDP, equities are near the highest they have been in the past 30 years at 120% of global GDP, as shown in the chart below.

On the surface, this appears concerning.

But let's peel back the onion.

Although valuations are high, they appear somewhat reasonable with current high growth rates and nearly $11 trillion monetary base. More on that below.

Lower interest rates also support higher valuations. The Fed cut another 0.25% last week. That's a total of 1.5% of cuts in the past year. Currently, there is an 81% chance of another 0.25% rate cut at December's Fed meeting.

Equity valuations are also supported by the fact that more companies within the S&P 500 have growth rates that are higher than what they have been historically.

The trend in the market over the past 30 years has shifted from stable, more established companies that tend to have high capital expenditures to one composed of growth-oriented companies in the tech space.

The market and economy today are quite different than they were 30 years ago.

The tech sector has consistently risen in importance since the mid-1990's, and we can see this trend reflected in the sector weightings within the S&P 500.

The next chart shows how the makeup of the S&P 500 has changed over time, courtesy of Morningstar.

The blue-ish line floating away higher and to the right than everyone else is the tech sector weighting.

Currently, it accounts for 35% of the market cap of the S&P 500.

However, if you include companies like Google, Meta, Netflix, EA Sports and others that used to be in the tech sector, but have been moved out, the percentage is closer to 50%.

Compare this to 1990, when technology made up only 6% of the S&P 500.

This shift pulls the average valuation of the market higher over time, as higher growth rates in earnings and profitability support higher valuations.

So let's look at earnings next.

Earnings

Valuations are a function of two things: the stock price (P) and earnings per share (E). Thus, the P/E ratio.

Over the short-term, markets tend to trade on emotions.

Over the long-term, however, markets "follow the money". That means earnings, economic growth, profitability, cash flow and other factors tend to drive stock prices over longer periods of time.

Since 2023, and more broadly since 2020, earnings have been rapidly increasing.

This is also a characteristic of bull markets.

The next chart shows earnings per share for the S&P 500, Nasdaq 100 and Dow Jones Industrials, and they continue to be very strong.

This chart suggests that the move over the past three years has been justified by solid earnings growth.

In fact, despite a slight pause growth in Q2 this year from tariff uncertainties, earnings projections have surged, supporting the move higher this year.

Not only are earnings making new highs in dollar terms, they are accelerating.

The next chart shows that the growth rate within the S&P 500 has jumped nearly 3% in October alone.

Earnings growth is fuel for a bull market.

But not all earnings are equal.

Profitability may be even more important, as PROFITS support higher valuations more than EARNINGS.

And tech stocks tend to have both higher earnings per share and higher profitability per share.

What if the P/E ratio was adjusted to account for profitability?

Would the market still seem expensive?

Duality Research puts out beautiful charts. Follow on X here: https://x.com/DualityResearch

This chart shows P/E adjusted for profitability.

This chart shows the adjusted P/E ratio along the top. This adjustment helps normalize the data series for profit margin differences over time.

In English, that means that companies with higher profits demand a higher valuation. And this adjustment factors in the differences in profitability of the overall market over time.

The bottom of the chart shows profit margins.

The S&P 500 profit margins have increased from a low of 7% in the 2008 financial crisis to a current reading of 14.4%. Profitability has doubled!

A quick illustration....which company should be more highly valued?

Company A with $100 of revenue and $7 of profit
Company B with $100 of revenue and $14 of profit

Hopefully you said Company B.

Longer=term profit margins on the S&P 500 typically range from 8-10% annually, depending on the economic environment.

It is not a coincidence that the market's increased exposure to technology stocks has resulted in an increase in overall profit margins.

Normalizing for profitability, the current P/E ratio is only 17.8, much less than the P/E of 24 that of the plain vanilla P/E ratio.

When factoring in profits, the market is not overly expensive at all.

Valuations are not good Timing Tools

The main problem with using valuations in stock analysis is that they are dependent on the price itself. So a bull market naturally increases valuations as prices rise, and vice-versa in a bear market.

Does that mean valuations are not important to watch?

Sort of.

Valuations are a condition, not a signal.

We should pay attention to valuations, but we should NOT use them as a tool that prompts action.

The next chart shows the relationship (or lack thereof) between P/E multiples and one-year forward returns.

This chart is useful not for what it shows, but for what it doesn't show.

Let's dip down into the statistical weeds briefly to explain the chart...

The chart shows an independent variable (P/E Ratio) versus a dependent variable (forward return). From a statistical standpoint, the formula "R-squared" describes how much of a dependent variable's move can be explained by the movement of the independent variable.

A reading of 1 would show that 100% of the forward return can be explained by the P/E Ratio.

Conversely, a reading of zero would show that P/E Ratios have no statistical dependence on forward returns.

For this data set, the R-squared is -0.01. Pretty dang close to zero.

Okay math nerd, back in the dungeon you go.

In other words, from a statistical standpoint, valuations have NO INFLUENCE to one-year future returns.

Say what?

You heard that right.

One of the most talked about data points in equity markets, valuations DO NOT MATTER to forward returns over the next year.

Just today, the blowhards on CNBC were saying markets were at risk because valuations are high.

But no correlation exists.

The only visible correlation we can find is that in the very lowest valuations (a reading of just over 5), limits downside to roughly 20%, but that isn't anything to write home about.

Ironically, the most common valuation level, right around 21, has been the starting point for both the best and worst one-year returns in the stock markets since 1957.

As we mentioned earlier, the current forward P/E ratio is 24 for the S&P 500.

Returns over the next year ranged from up 40% to down 40%. And the average 12-month return at this level is positive.

This is a data point to keep our eye on, but not one that is useful as a signal to buy or sell.

One more specific example is Nvidia (ticker NVDA), shown in the next chart below.

This is an extreme example of a stock with massive growth in revenue, profits and stock price.

In this example, the stock price went up 5x and the P/E ratio was cut in half.

As the bull market advances, we anticipate that more and more people will be calling for lower prices based on valuations being high.

But the data suggests that using valuations as a meaningful part of an investment process only adds risk through the cognitive biases of the investor.

Stocks and the Monetary Base

Another characteristic of the current environment that should be supportive of the market is the dramatic increase in the monetary base.

The monetary base is the total currency within a country.

When the Fed started printing money like a drunken sailor in 2009, the relationship between GDP and stock values became disconnected.

In this chart, the dotted line is US GDP, while the blue and black lines show the increase of the money supply and the total value of all US shares outstanding respectively.

One thing to notice on this chart is the separation that began in 2010, as Bernanke embarked on the massive gamble of implementing quantitative easing across the globe.

One major risk in our view over the next few years is the real potential of the Federal Reserve being shut down.

The increase in liquidity within the financial system has helped stocks grow for the past 15 years.

Would closing down the Fed cause a removal of this massive liquidity and potentially tank the markets?

Maybe.

One thing is for sure: we cannot rule out the potential for major dislocations, up or down.

Ultimately, we think that getting rid of the Fed would be a good thing. Replace the Fed Funds rate with the 2-year Treasury yield, and get the human error out of monetary policy.

The Fed has created some of the most egregious misallocations of capital in history, and the financial system would be far better off without them.

Especially if we find out that the Fed has been involved in illegal activity around the world.

However, the path towards eliminating the Fed could be messy, and has no historical precedent.

A post-Fed world would, however, be much better for citizens of the United States by removing a massive, unnecessary cancer on the financial system.

Case in point...watch this video.

This is Jared Bernstein, the Chair of the Council of Economic Advisors under the Biden administration. He has no clue what he is talking about and that is incredibly scary.

None of this makes sense.

The leaders don't know how it works, there is no transparency on where the funds go, no accountability when they wreck the economy, and no apologies when they cause massive inflation at the expense of hard-working individuals trying to get by.

We will keep you up to date on developments with the Federal Reserve, but we strongly suggest you keep an open mind over the coming months and years to what may really be happening behind the scenes.

Bottom Line

The market has been strong. That's what happens in bull markets.

Corrections in bull markets tend to be sharp, scary and swift. That is the trend we have seen over the past few years and one that we continue to see literally today.

At some point markets will experience a larger correction.

But for now, the data supports higher prices at least through mid-2026. Possibly further.

Invest wisely!