The conclusion of the last financial year marked significant gains for the stock market, yet concerns loom over high valuations that resemble those seen during past economic bubbles, such as the dot-com era and the Covid-19 pandemic. In 2023, the S&P 500 experienced a notable rally, propelled primarily by technology companies, culminating in a rise of over 16%. This trend follows a robust performance that began in late 2022, with the index gaining more than 24% in 2023 and 23% in 2024.
However, investors seeking bargains may find the current landscape discouraging. The cyclically adjusted price-to-earnings (CAPE) ratio, a valuation gauge created by Yale University economist Robert Shiller, reached 40 at the year’s end. This figure, along with the S&P 500’s forward price-to-earnings ratio exceeding 22, raises alarms about potential long-term returns. Mebane Faber, chief investment officer at Cambria Investment Management, expressed caution, pointing out that such a high CAPE ratio historically leads to future 10-year returns averaging close to zero, after adjusting for inflation. Faber stated, “While this isn’t a red flashing light that stocks have to crash, it is a yellow warning that the broad market is expensive.” He noted that research has shown no instances where a CAPE ratio of 40 has resulted in above-average returns over the subsequent decade.
On a positive note, Faber highlighted that many international markets remain “cheap to very cheap,” suggesting opportunities outside the U.S. Furthermore, within the domestic market, value stocks and small- and mid-cap companies may present better investment prospects compared to the megacaps that dominate the index. Keith Buchanan from Globalt Investments acknowledged that the elevated CAPE reading primarily stems from a select few stocks, recommending diversification to enhance performance. “Diversification is the key to outperformance going forward in 2026,” he advised, emphasizing a focus on lower-median valuation stocks.
In contrast, some analysts argue that current valuations may not be a pressing concern. Venu Krishna, head of U.S. equity strategy at Barclays, remarked that although a forward price-to-earnings ratio of 22 is not intrinsically cheap, it has historically not impaired returns if earnings per share (EPS) growth remains positive. He acknowledged that while current estimates for forthcoming earnings growth might be overly optimistic, a double-digit EPS growth is still anticipated for the S&P 500 in the current year.
As the market navigates these high valuation waters, investors are encouraged to look beyond the surface and consider diversification and potential opportunities in undervalued stocks, both domestically and internationally, to balance their portfolios strategically.
