S&P 500: Will US stocks move higher despite price-to-earnings at highest level since March 2022?
By Nigel Green
The US stock market has surged in recent months, propelled by optimism that the Federal Reserve is orchestrating a soft landing for the economy.
At 23.35 times next year’s earnings, the forward price-to-earnings (P/E) ratio on the S&P 500 is at its highest level since March 2022 and sits 1.5 standard deviations above the 25-year long-term average.
To some, these elevated valuations might suggest the market is pricing in perfection, leaving little room for disappointment.
But this viewpoint may be overly cautious.
In reality, there are solid reasons to believe the market still has room to grow – even from these already lofty levels.
First, it’s important to recognize that the US economy has been resilient, and a favorable combination of declining interest rates and solid economic growth could further drive corporate earnings.
The Fed’s battle against inflation seems to be winding down as inflationary pressures ease, creating an environment that supports continued growth without triggering a recession. This is the essence of the soft landing scenario.
But here’s the kicker: even if much of this outcome is already priced into the market, the momentum from ongoing growth can still push the market higher.
Companies are adjusting to a new normal, and as they streamline operations and capitalize on lower borrowing costs, earnings can exceed expectations. The rally, therefore, may not just be about what’s priced in today, but also what could be accomplished tomorrow.
Critics will point to the elevated P/E ratio as a reason for caution, arguing that the market is expensive and vulnerable to a pullback.
However history shows that the P/E ratio can remain elevated for extended periods, especially during times of robust earnings growth and declining interest rates.
In fact, the 1.5 standard deviations above the 25-year average may not indicate overvaluation as much as it reflects the market’s confidence in a sustained economic recovery.
When interest rates fall, stocks typically become more attractive compared to bonds, which drives up valuations. If the Federal Reserve continues to ease monetary policy, this dynamic could easily support even higher P/E multiples.
While the current ratio may appear stretched, the reality is that it could be the new normal in a lower-for-longer interest rate environment. Investors should be prepared for the possibility that valuations will stay elevated as long as the economy continues to deliver.
One area where there could be significant upside is in the technology sector.
Tech stocks have driven much of the market’s gains in recent years, and they remain well-positioned to benefit from a low-interest-rate environment.
With financing costs set to decline, these companies are likely to ramp up innovation and expansion, potentially delivering outsized earnings growth that the market has yet to fully appreciate.
Additionally, the rapid advancements in artificial intelligence (AI), cloud computing, and other cutting-edge technologies are creating new revenue streams that could drive earnings beyond current projections.
The tech-heavy Nasdaq has already shown strength, and as these industries continue to expand, there’s room for even more growth.
Given the role technology plays in driving economic productivity, the sector’s dominance in the stock market is justified and could push valuations higher still.
Earnings growth could outpace expectations
Another factor that could propel the market is the potential for earnings growth to surpass expectations.
Analysts’ forecasts are often conservative during periods of uncertainty, and the current environment is no exception.
The market is betting on steady earnings growth, but there’s a strong chance that companies, particularly in sectors like technology, consumer goods, and healthcare, could deliver stronger-than-expected results.
(Author is deVere Group CEO and Founder)
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