It’s official, my long-term market timing model has confirmed a buy signal at the end of June. It first flashed a sell signal in late January when the 14-month RSI of the NYSE Composite exhibited a negative divergence when the market made a new high, but RSI didn’t. Now it flashed a buy signal at the end of June when MACD recycled from negative to positive (bottom panel), though you have to squint to see when it went negative in May.
This model has shown a strong track record over the years. If you had sold in late January and bought back in when the S&P 500 made a new high last week, you would have missed the tariff drama drawdowns of the last few months.
In my discussions with investors, one key question keeps coming up. The S&P 500 is trading at a forward P/E of 22. Can a new bull truly begin at such elevated valuations?
Reasons for Caution
There are good reasons to be cautious. The S&P 500 is trading at a forward 12-month P/E ratio of 22. Investors have seen such valuation levels in the last 30 years on only two occasions, the COVID era and the dot-com era.
Can stock prices advance from here? The answer is a qualified yes, though there are reasons to be cautious.
The last time the S&P 500 reached a forward P/E level of 22 was in 2020 during the COVID era. Then the E in the P/E ratio was falling dramatically, which elevated the forward P/E ratio. Earnings estimates recovered soon after, and stock prices advanced because the E in the P/E did most of the heavy lifting.
Fast forward to 2025. Earnings estimates saw a minor setback during the latest trade war tantrum and began to recover. Though the drop in earnings was less dramatic than 2020, the market’s forward P/E is nevertheless lofty by historical standards.
There are two ways stock prices can rise. Either the E in the P/E rises or the P/E ratio rises further.
Strong Momentum
Street analysts are forecasting a bottom-up aggregated annual S&P 500 growth to be 9% in 2025, 14% in 2026 and 12% in 2027. As they stand today, those figures should translate into healthy stock price returns, as long as the forward P/E multiples hold at current levels.
In the short run, the market is seeing signs of strong momentum. FactSet reported that the rate of forward EPS guidance for the coming quarter has been rising and levels are well above their historical averages. That’s a sign of strong positive fundamental momentum, which should be supportive of stock prices.
The P/E Outlook
For the longer-term outlook, investors need to consider how P/E multiples will evolve. The P/E multiple is a function of interest rates and bond yields.
Let’s begin with the outlook for short-dated rates. Fed Chair Powell admitted at the ECB forum in Sintra last week that, were it not for Trump’s tariffs, the Fed would be easing rates. Labour markets are showing signs of some softness. The stronger-than-expected June Payroll Report paints an apparent picture of a resilient jobs market. However, weaker-than-expected average hourly earnings, average weekly hours and a decline in the participation rate tempered the headline strength of the report.
The stronger-than-expected June Payroll Report moved the needle on market expectations in a hawkish direction but likely didn’t move the needle on Fed policy outlook. The June Summary of Economic Projections (SEP) shows that Fed officials raised their unemployment rate projections for 2025. The June unemployment rate of 4.1% was stronger than expectations, though the decline in unemployment can be explained by an unwelcome retreat in the participation rate.
The internals of the report came in on the weak side. Most of the job gains were attributable to increases in healthcare and government jobs. The diffusion rate of job gains was below 50, which indicates a negative breadth in employment increase. Take together, this is consistent with the SEP projection of a gradual weakening in the jobs market.
In addition, the Fed is hesitant about cutting rates because it doesn’t know the full effects of the tariffs. Will tariff-induced price increases be a one-time shock or will the Trump Administration continue to rachet them up over time? The current environment raises stagflation risks of weakening growth and rising inflation.
The internals of the report came in on the weak side. Most of the job gains were attributable to increases in healthcare and government jobs. The diffusion rate of job gains was below 50, which indicates a negative breadth in employment increase. Take together, this is consistent with the SEP projection of a gradual weakening in the jobs market.
In addition, the Fed is hesitant about cutting rates because it doesn’t know the full effects of the tariffs. Will tariff-induced price increases be a one-time shock or will the Trump Administration continue to rachet them up over time? The current environment raises stagflation risks of weakening growth and rising inflation.
While Powell has described current monetary conditions as moderately restrictive, monetary policy can’t be described as overly tight. The Cleveland Fed’s estimate of the Fed Funds rate using a variety of rules and assumptions shows that the current median estimate is equal to the current Fed Funds target of 4.25–4.50%.
Consider how market expectations have evolved in the last year, from the Fed’s perspective. The 2-year Treasury yield, which measures the market’s expectations of the long run Fed Funds rate, fell after the tariff wars began in late January after Trump took office and it’s been in a narrow range since early March. By contrast, the 10-year Treasury yield has been range-bound since Trump’s Inauguration. The 2s10s yield curve rose sharply after the “Liberation Day” announcements and it’s been relatively steady since, which is a signal of elevated inflation expectations.
Having addressed the issues surrounding the Fed Funds outlook, investors also have to consider how the 10-year rate will evolve, which is a function of White House policy on the budget and the trade war.
One wildcard is the budget bill that’s making its way through Congress. The non-partisan Congressional Budget Office estimates the Senate version of the bill passed last week will add $3.3 trillion to the U.S. deficit over 10 years, compared to the House version, which would only raise the deficit by $2.8 trillion over the same period. The bill that eventually passed in the House on July 3 was the higher-deficit Senate version.
The one piece of good news is Section 899, the so-called “revenge tax” that penalizes foreign investors domiciled in countries judged to have unfair tax regimes, was eliminated from the final version the bill.
In the meantime, global markets have become increasingly nervous. While the 10-year Treasury yield has fallen in absolute terms, a basket of foreign sovereign bonds is outperforming Treasuries on a USD and equivalent-duration basis. As well, the USD Index is weakening. While the reduction in 10-year yield represents good news for the P/E ratio as lower yields represent less competition for stocks, worsening relative bond performance and USD weakness are concerns for the relative competitiveness of U.S. stocks compared to global equities.
Consider how market expectations have evolved in the last year, from the Fed’s perspective. The 2-year Treasury yield, which measures the market’s expectations of the long run Fed Funds rate, fell after the tariff wars began in late January after Trump took office and it’s been in a narrow range since early March. By contrast, the 10-year Treasury yield has been range-bound since Trump’s Inauguration. The 2s10s yield curve rose sharply after the “Liberation Day” announcements and it’s been relatively steady since, which is a signal of elevated inflation expectations.
Having addressed the issues surrounding the Fed Funds outlook, investors also have to consider how the 10-year rate will evolve, which is a function of White House policy on the budget and the trade war.
One wildcard is the budget bill that’s making its way through Congress. The non-partisan Congressional Budget Office estimates the Senate version of the bill passed last week will add $3.3 trillion to the U.S. deficit over 10 years, compared to the House version, which would only raise the deficit by $2.8 trillion over the same period. The bill that eventually passed in the House on July 3 was the higher-deficit Senate version.
The one piece of good news is Section 899, the so-called “revenge tax” that penalizes foreign investors domiciled in countries judged to have unfair tax regimes, was eliminated from the final version the bill.
In the meantime, global markets have become increasingly nervous. While the 10-year Treasury yield has fallen in absolute terms, a basket of foreign sovereign bonds is outperforming Treasuries on a USD and equivalent-duration basis. As well, the USD Index is weakening. While the reduction in 10-year yield represents good news for the P/E ratio as lower yields represent less competition for stocks, worsening relative bond performance and USD weakness are concerns for the relative competitiveness of U.S. stocks compared to global equities.
Interpreting the Buy Signal
Putting it all together, where does that leave us? Can stock prices advance when the S&P 500 is trading at a historically high forward P/E of 22?
I interpret the buy signal two ways. First, it’s taking the odds of a significant bear market off the table. On the other hand, an elevated P/E of 22 will limit the upside of U.S. equities, but not global equities. U.S. stocks have handily beaten the rest of the world since the GFC that a generation of investors have conditioned themselves to think of the global stock market outlook as being driven mainly by the U.S. A review of the relative performance of regional markets shows that the S&P 500 and NASDAQ 100 are underperforming global markets on a YRD basis, but they have recovered since the April “Liberation Day” bottom. The recent recovery can be seen in U.S. stocks and EM ex-China, whose markets are supported by a weak USD. The relative losers in the latest recovery are Europe, Japan and China.
While U.S. equities are expensive by historical standards, the valuation of other regional markets is far more reasonable.
Macro conditions may be setting up for a cycle of superior non-U.S. equity outperformance. Investors are already seeing preliminary signs of the “Sell America” trade by the bond and currency markets. If history is any guide, persistent USD weakness has led to non-U.S. stock outperformance.
In conclusion, I interpret the buy signal from my long-term market timing model as a buy signal for global equities, and not just the U.S. market. While the U.S. stock market faces a number of macro and valuation challenges, non-U.S. stocks enjoy cheaper valuations and more earnings growth tailwinds compared to the S&P 500.
While U.S. equities are expensive by historical standards, the valuation of other regional markets is far more reasonable.
Macro conditions may be setting up for a cycle of superior non-U.S. equity outperformance. Investors are already seeing preliminary signs of the “Sell America” trade by the bond and currency markets. If history is any guide, persistent USD weakness has led to non-U.S. stock outperformance.
In conclusion, I interpret the buy signal from my long-term market timing model as a buy signal for global equities, and not just the U.S. market. While the U.S. stock market faces a number of macro and valuation challenges, non-U.S. stocks enjoy cheaper valuations and more earnings growth tailwinds compared to the S&P 500.
5 thoughts on “Can a New Bull Begin at a Forward P/E of 22?”
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If you sold in January, and bought now, you’d be better off never having sold.
But you would have missed the gut-wrenching downside volatility. Would you have been panicked out at the bottom? I have no idea.
YMMV
It would seem that based on your assessment investing in global ETFs outside of the U.S. market should also be conditioned with hedges against the U.S. dollar?
Thanks
I don’t understand the question. Historically, non-US stocks have outperformed during prolonged periods of USD weakness.
OTOH US stocks are highly valued when compared to the rest of the world today. So what’s your question?
When you purchase an ETF for say Japan, if you do it without hedging the weak dollar against a stronger yen, and you are an US investor, I would assume your return in Japan is diminished buy the weaker dollar here? My question is, in general, under your scenario, using Japan as an example, would it make more sense to invest in DXJ vs EWJ?
Thank you