The S&P 500 Just Did Something Extremely Rare— and Concerning

A photo from the floor of the New York Stock Exchange on Monday. (Michael M. Santiago/Getty Images)

The S&P 500’s valuation has jumped so quickly, it is worrisome.

Its rally since its April low has brought it to 22 times the combined per-share earnings analysts expect for its member companies over the next 12 months. Not only is that the top of its range in the past three-and-a-half years, but it has come back all the way from 18 times at the low.

The market does have some reasons for confidence. It sees a greater chance that the White House will complete trade deals. And even with some tariffs in place, inflation has remained low enough to keep Federal Reserve interest rate cuts on the table this year. That would keep the economy growing, allowing for more growth in corporate profits.

The problem is that the price/earnings multiple hardly ever rises this much in less than three months. According to Rosenberg Research, such a fast expansion is a “4-sigma event,” which means the P/E multiple deviated from its mean, or its expected value, by four standard deviations. Based on data going back to 1990, the odds of it happening are less than 1%.

When it happens, it signifies the market is about to see another large move.

The good news is that sometimes, such a rise in valuation indicates another impressive rally is on the way. For all of the dates in 2020 when the S&P 500’s P/E was four points greater than it had been three months prior, or less, the following 12 months saw a gain of greater than 30%, according to Dow Jones Market Data.

Early that year, after the start of the Covid-19 pandemic had triggered a spectacular market decline, the market was looking ahead to an economic recovery. Traders and investors alike were pricing in what was to come in 2021—reopenings and trillions of dollars of fiscal and monetary stimulus—correctly betting that earnings would snap back to normal levels.

A similar dynamic unfolded in 2009. For all of the dates that year when the S&P 500’s P/E was four points greater than it had been three months prior, or less, the following 12 months saw a gain of at least 13%. The market was anticipating the end of the 2008-2009 financial crisis.

But when multiples expand super quickly at the end of an economic expansion, not near the start of a new one, the market is usually in for losses. In May 2001, the index’s P/E multiple had risen four points in less than three months, but the economy had entered a recession that wouldn’t end until 2002. The index fell 17% over the next year.

That is eerie when considering what’s happening today. While the U.S. economy surged as it recovered from Covid-19 in 2021, inflation followed in 2022, forcing the Federal Reserve to raise interest rates. The market has been on recession watch most of the time since then.

While a “soft landing” looks to be unfolding, and Big Tech earnings have taken off as a result of artificial intelligence, the U.S. economic expansion is currently seen as in its later stages. Any number of risks could further reduce growth.

Tariff-driven inflation could worsen because some companies are still planning to lift prices further. That could delay rate cuts and slow the economy.

Another danger is the near certainty that President Donald Trump’s One Big Beautiful Bill will increase the budget deficit. The Treasury would have to borrow more money, lifting bond yields and sending borrowing costs higher across the economy.

While there is a view that higher valuations for stocks are the new normal—the reasoning is that Big Tech can achieve rapid earnings growth for many years to come—the S&P 500’s 22 times earnings may indeed be too high. Earnings in many sectors, including tech, could miss expectations as the risks play out.

The index’s expensiveness would bring it lower. Since rates rose from 0% in early 2022, investors have tended to stay away from the S&P 500 when it reaches roughly 22 times earnings. That signals investors have some nervousness about the S&P 500, which makes sense considering the risks to earnings.

Maybe the market is in for a large drop. Even if it isn’t, it looks a little too expensive for a smart investor to buy in right now.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com