Are Investors Paying a Peak Multiple for Peak Earnings in the Key US Equity Market?
As we know, stock markets go to excess both on the upside and downside. Rarely do the fundamentals that drive markets over the medium- to long-term vary that much, so it is often monetary and fiscal policies (too loose or too tight) along with investor sentiment that drive markets to extremes. In an attempt to answer the question posed in the title we need to revisit the long-term drivers of stock market returns in the US, and we will use the S&P 500 Index as a guide given that the data required is more easily available for this index over long periods of time.
The first table on the right highlights the returns from the S&P 500 Index from 1950 to 2025 inclusive (a 76-year period). Annual price returns have been 8.20% and when you add in the average dividend yield received in cash by investors of 2.92% the annual total returns come out at 11.12%. Further down the table, we analyse the three drivers of those returns:
- (GAAP) Earnings of the 500 companies in the index grew at 6.32% annually. Higher earnings justify higher share prices, so that it is the growth in corporate earnings that is the main driver of stock market returns over the long-term.
- The dividend paid to investors in cash (out of those earnings) averaged 2.92% annually; and,
- A higher valuation on those earnings today compared to 1950 added another 1.88% annually to those returns.
At the start of 1950, investors were paying just 7.2 times earnings. At the time of writing, investors are paying 28.0 times 2025 expected earnings of $244.12 per index share. US stocks are more expensive today compared to the start of 1950 and that has added 1.88% annually to returns over the 1950-2025 period. Or perhaps we should say: US stocks were incredibly cheap at the start of 1950. After two world wars and a great depression in the 1930s, that shouldn’t be surprising.
Moving on to the question of whether S&P 500 earnings are running above trend, the evidence suggests so. As we already mentioned, S&P 500 earnings have grown by 6.3% annually from 1950 to 2025 inclusive. It’s important to recognise that the growth in corporate earnings is linked to the growth in economic output (GDP) – itself driven by employment growth and productivity gains – and augmented by the use of leverage (borrowings/debt).
That rate of growth in S&P 500 Index earnings has been fairly constant over the decades. Earnings growth was stronger in the 1970s reflecting the boost to earnings from inflation which averaged 7.1% annually in that decade. Over the entire 76-year period, inflation averaged circa 3.5% annually, so that the real growth in S&P 500 earnings was a healthy 2.8% annually.
The second table on the right also highlights the growth in earnings following previous economic setbacks. S&P 500 earnings registered a cyclical peak in 1999 just prior to the bursting of the Internet bubble. Yet, from that earnings peak, earnings grew modestly above the average long-term rate (6.4% annually) from then to the present time (1999-2025). The same can be said for earnings post the Global Financial Crisis. S&P 500 Index earnings registered a cyclical peak in 2006, and have grown 5.9% annually since, and modestly below the long-term average of 6.3%.
Yet, since the peak in S&P 500 Index earnings in 2019 prior to Covid-19, earnings growth has accelerated to 9.8% annually. Inflation has only been modestly higher at 3.9% annually over this 6-year period compared to the 1950-2025 average, so inflation is not the (sole) cause of this acceleration in S&P 500 earnings growth.
In a recent paper by Research Affiliates titled ‘How Deficits Inflate Profits and Equity Valuations’, the authors argue that it is the US budget deficits that are responsible for the above-average growth in S&P 500 earnings. You can click the link for access to that article.
The chart opposite highlights the US budget deficits since 1981. And it’s clear that since the Global Financial Crisis the US Government has persisted with above average budget deficits. The point Research Affiliates makes is that budget deficits add demand to the economy and directly inflate corporate earnings.
Many argue that US corporate earnings are higher as a percentage of GDP today because the large US tech companies have stronger competitive advantages, better margins and better growth prospects than companies in times gone by, and that the latest technological innovation, Artificial Intelligence (AI), is adding to those advantages. Research Affiliates article suggests otherwise, arguing instead that ‘those alternative theories help explain the distribution of earnings among firms but not the aggregate level of those earnings’. That’s a very useful clarification and has cleared up some confused thinking previously on our part.
So, it seems reasonable to conclude that S&P 500 Index earnings are currently above trend and that the cumulative US budget deficits are responsible for that. Does that mean peak earnings?
Not necessarily. As Isaac Newton’s theory of motion states; ‘A body in motion will remain in motion until a force acts on it.’ In other words, if the US government keeps spending beyond its tax receipts and plugging the gap with borrowings, then US corporate earnings can remain above trend. Any reversal or reigning in of this excessive government spending, however, would negatively impact US corporate earnings growth and perhaps bring them back into line with the long-term trend, which is GDP growth plus a bit.
The next question to answer is; are investors paying a peak valuation for these (possibly) peak earnings? Said another way – is the valuation of US equities at an extreme? The next chart is fairly persuasive in that regard and suggests yes. We have copied the chart from another publication, but its source is Bloomberg, which is a highly credible source and to which we subscribe.
The chart is hard to read, so let us assist. It is a composite of several different valuation metrics, such as the price-to-earnings ratio, price-to-book value ratio, price-to-sales ratio etc. The percentile rank of each ratio is calculated at each point in time (for example, a 99th percentile rank means that the ratio at that particular point in time is in the top 1% of all observations) and an average is taken of combined ratios’ percentile ranks. On the chart, zero (0) corresponds with the cheapest valuations on record and 100 with the most expensive.
The chart highlights that (today) investors are valuing S&P 500 companies at the highest level since 1901. Other periods where valuations were also near the current peak include 1929, 1966 and 1999. 10-year returns from US equities following each of those previous three peak valuation periods were miserable.
As if to corroborate the danger, the following chart hints at a similar risk. It highlights the level of equity ownership by US households since 1945 (the blue line is represented by the left-hand scale).
Today, equities account for almost 55% of US household assets. That’s a new peak. The orange line represents the subsequent 10-year returns from the S&P 500 Index (represented on the right-hand scale). Looking forward, if past correlations hold true, and we see no reason why they would not, over the next 10 years, the orange line can be expected to follow the blue line, which suggests that 10-year returns from here are likely to be in the zero area (right-hand scale). That’s what occurred at each previous peak in equity ownership in the US since 1945 i.e. at the peaks in 1966 & 1999.
So, while we can’t tell whether S&P 500 Index earnings are at a peak, we can conclude that they are most likely above the long-term trend. We can further conclude that we are at a valuation peak relative to historical averages. Interest rates are lower today compared to previous valuation peaks, and that is an argument in support of ‘it’s possibly different this time‘. Against that, the level of equity ownership among the average US household is also at a new peak, and this latter indicator is independent of interest rates.
Does this mean that the S&P 500 Index is about to enter a sharp decline? Not necessarily. What is fairly clear is that both US fiscal and monetary policies are loose at present and that is normally good for the US equity market. The problem for investors is that the risks are well above average (and have been for some time) and history suggests that returns on a 5-10 year view from here from US equities could be unusually low.
What could act on S&P 500 earnings and valuations to crystallise these risks?
- An increase in US long-term interest rates perhaps led by:
- an uptick in inflation.
- Investor nervousness over US government debt levels – which are being driven increasingly higher by the constant US budget deficits – to the extent that investors sell US long-dated bonds, thus raising the level of long-term interest rates (lower bond prices translate to higher bond yields, or higher long-term interest rates).
- A reduction in spending by the US Government leading to a contraction in the budget deficit, and a likely corresponding contraction in US corporate earnings.
- A recession – which can occur at any time.
Investors are excited about the potential productivity gains from AI. However, it is worth bearing in mind that the 6.3% annual growth in S&P 500 Index earnings since 1950 incorporates all the productivity gains from technological improvements along the way. So, a pertinent question is, would you pay 28 times earnings for 6.3% annual earnings growth? A price-to-earnings ratio of 28 is equivalent to an earnings yield of 3.57%. A risk-free US Government 10-year bond currently offers a yield to redemption of 4.17%, although investors in such a bond won’t benefit from any growth in that yield over the 10-year period to maturity.
There are a number of ways to lower one’s risk to a likely overvalued US equity market:
- Lower your weighting to the key US equity market.
- Use equal weighted ETFs:
- In mid-2024, we introduced coverage of the S&P 500 Equal Weighted ETF
- In late-2025, we introduced coverage of the iShares MSCI Global Equal Weighted ETF. Both ETFs reduce the stock specific risks and heavy concentration of leading US stocks in the traditional market value weighted S&P 500 ETF and World equity ETFs as well as lowering the average valuations.
- Focus on value-oriented funds (if you don’t wish to select stocks):
- In mid-2021, we introduced coverage of the iShares MSCI Global Value Factor ETF
- In mid-2024, we introduced coverage of the Smead US Value Fund.
It’s near impossible to time when ‘the tide turns’ in markets but the technical indicator we follow on US equity markets, Dow Theory (for the 21st Century), is as good as any at alerting us to a potential turn in the tide. Today, the indicator remains in ‘Buy’ mode, but we remain alert!
Investment clients that share our concerns regarding the valuation of the key US equity markets should discuss it further with their investment advisor.
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