Stock Valuations Are High and That’s Perfectly Fine

The S&P 500 just posted a total return of at least 25% for the second year in a row. That hasn’t happened since 1998.

Not too shabby.

The downside of this epic rally is that howling about excessive valuations is everywhere. Everyone seems to agree stocks are too rich.  

Here’s the deal: Stock valuations are elevated and that’s perfectly fine.

If you’re searching for a constructive argument about US equities, I’ve got you covered.

Today, I’ll highlight several underappreciated bullish macro signals that will continue to support equity valuations. Then, I’ll lay out the best way to outperform.

Grab a coffee. Then hug a bear…they’ll need it.

Stock Valuations are High and That’s Perfectly Fine

Before we delve into why you shouldn’t worry about high valuations, let’s check in on where multiples stand across the stock market.

Here’s the headline: There’s no evidence of elevated valuations outside of big tech, where higher multiples are justified by superior growth.

Let’s dig deeper.

While the S&P 500’s forward multiple of 21X is well above its long-term average of 16.6X, that’s only because the Magnificent Seven’s S&P index weighting has soared to 33%.

Years of superior profit growth have pushed the Mag 7’s forward PE up to a hefty 29X. And there’s no sign of an end to big tech’s earnings supremacy.

Consensus sees the Mag 7 posting 21% 2025 EPS growth vs. only 13% for the S&P 493.

As for everything else, valuations are roughly in line with their 20-year averages (chart).

We all know stocks follow the economy, earnings and interest rates.

Let’s run through these 3 key macro inputs one by one to see what they signal for valuations.

Valuations Track Economic Growth

We’ll start with the economy. It turns out valuations have an upward bias in non-recessionary periods but drop sharply around economic contractions (chart).

With current recession risks contained, multiples are most likely to drift higher in 2025. In early cycle years, P/Es expand by 2.7 turns.

Rising P/Es are perfectly fine in today’s environment:

Valuations Rarely Contract When the Fed is Easing & Earnings Growth is Above Average

When policy is easy and earnings are thriving, enjoy the ride.

These 2 levers combined, create richer valuations.

Since 1980, the S&P 500 has averaged 9% annual forward PE expansion when EPS growth has been above trend and the Fed is loosening policy.

The positive hit rate is an impressive 91% with a max PE expansion of 22% and a max PE contraction of only 4%.

Check out this table:

When the good times are rolling along, crowd-stunning rallies occur!

OK but are rate cuts still in the cards? We believe so.

The Fed is Still Your Friend

The bears argue healthy 2.7% GDP growth and slowing disinflation mean the Fed is nearly done cutting rates.

After all, since falling sharply in 2022 and 2023, core PCE inflation, the Fed’s favorite price gauge, has been stuck around 2.8% for a year (chart). Meanwhile, percolating inflation fears are pushing up long-term rates.

While these factors are likely to mean fewer rate cuts, that doesn’t mean easing is over.

Here’s what the bears miss. The Fed’s monetary policy is still too restrictive. The Fed Funds rate minus CPI inflation is currently 1.68% vs. averaging just 1% since 1960 (chart).

Expect the Fed will keep cutting rates.

OK but do earnings justify high valuations?

Earnings Momentum is Double the Long-Term Average

Since 2005, the S&P 500’s average EPS growth rate is 7.1%.

2025 consensus forecasts of 14.8% easily check the “above average” box (chart).

The bottom line is above average profit growth should continue to underpin prices, especially in the tech sector where EPS growth is fastest and valuations are highest.

Today’s rich valuations are a function of ultra healthy earnings acceleration.

How to Play it

Our 2025 outlook highlighted our preference for cyclical sectors.

We’re still bullish on technology, it’s where the best growth is.

But with growth healthy and the Fed continuing to ease amid low inflation and a likely more benign tariff regime than initially feared, we also like other cyclical sectors like financials and discretionary too.

Notice how these 3 sectors top our latest sector rankings tracking big money buying interest:

Here’s The Bottom Line

The downside of this epic rally is that everyone seems to agree stocks are too rich. 

We beg to differ. Valuations follow fundamentals. Fundamentals are great.

While rising long-term interest rates will continue to drive short-term chop, don’t expect significant and lasting PE compression without a hawkish Fed or signs of recession and the earnings erosion that typically accompanies it.

Valuations have an upward bias in non-recessionary periods. With recession risks contained, multiples are unlikely to drop much in 2025.

Meanwhile, valuations rarely contract when the Fed is easing and EPS growth is above average. 2025 estimated S&P 500 EPS growth is 14% vs. the 7% long-term average.

Since 1980, the S&P 500 has averaged 9% annual forward PE expansion when EPS growth has been above average and the Fed has been easing.

So, there you have it. This market isn’t a bubble about to pop.

Cyclical sectors like tech, financials and discretionary should outperform.

Just ride the top-ranking stocks.

If you want to find specific small, mid and large cap financials, technology and discretionary stocks ramping with Big Money support, get started with a MAPsignals PRO subscription. It’ll get you access to our portal that updates every morning, showcasing the stocks getting bought and their scores.

MAP your own stocks and ETFs. AND you’ll get our prized Top 20 list in your inbox every Tuesday!

There are plenty of cyclical stocks poised to keep ripping in 2025. If you’re a Registered Investment Advisor (RIA) or are a serious investor, use a MAP to find them!

Invest well,

-Alec