The Stock Market Is Ridiculously Expensive. How It Could Get to Ludicrous.

The S&P 500 now changes hands for roughly 22 times 12-month forward expected earnings per share. (NYSE)

There’s the old adage that you get what you pay for. That’s one way to feel better about buying the S&P 500 at its current price.

All three major indexes closed at new records on Thursday, the fourth for the Dow Jones Industrial Average and the 24th for both the S&P 500 and Nasdaq Composite. That seems to fly in the face of September’s scary reputation, but easier to understand since earnings expectations keep rising, particularly for the biggest players, meaning it isn’t just empty optimism.

Of course, buying high quality sounds good until the check comes. The S&P 500 now changes hands for roughly 22 times 12-month forward expected earnings per share, and that’s a two-front problem, notes DataTrek Research Co-Founder Nicholas Colas.

The first issue is that while EPS estimates are heading higher, they can only do so much of the heavy lifting. Even if they manage to further surprise to the upside in the 3% to 5% range, that alone isn’t enough to boost the S&P 500 beyond low-single digit gains over the next year. To get double-digit returns like the past two years, multiples have to expand higher, too.

Here’s where it gets tricky. At 22 times forward earnings, the S&P 500 is already at a valuation last seen during the 1990s dot-com bubble and the pandemic era, when the market was pumped full of fiscal and monetary stimulus.

Hence the second problem: Everyone remembers how those movies ended.

To be bullish now means having to feel comfortable making the case for even higher multiples. Luckily, that isn‘t impossible.

In fact, as Colas notes, it requires little more than tech still doing its thing. To get the S&P 500 to 24 times forward earnings, the tech sector would only have to go from today’s multiple of 29 times to 31.5 times—a level already eclipsed by Microsoft, Broadcom, and Oracle, while Apple and Nvidia’s valuations are nearly there. Given that these five stocks alone are more than half of the tech sector with an average multiple of more than 36 times, it isn’t a stretch to see that expanding and leading the S&P 500 higher.

“This is the most straightforward path to a 24x S&P multiple, as it only requires that investors put a higher valuation premium on a single sector that already has a strong tailwind” in the form of artificial intelligence enthusiasm, Colas notes. “If other Tech names can convince the market their fundamentals are also accelerating, the group’s multiple improvement will follow.”

Tech isn’t the only sector though, and if the other sectors with at least a 10% weighting in the S&P 500 see multiple expansion that’s another path to a higher overall multiple for the index.

Consumer discretionary and communications are already heavily exposed to big tech, making it easy to understand how AI bullishness could spill over to these sectors.

Colas admits that a big valuation boost for financials is a bigger ask, but believes the sector does deserve a positive rerating. Add in interest rate cuts, a steady economy, and a lack of geopolitical surprises and it seems a lot more plausible—for financials as well as other sectors, too. That gets the index closer to a multiple of 26 times, able to support 17% to 18% gains over the next year or two.

Still, it’s worth noting that neither scenario is bad. With tech alone enjoying higher multiples that still equates to an 8% to 9% price return over the next couple of years. That only seems disappointing in relation to the index’s recent annual gains of more than 20%.

“We strongly believe the 8% to 9% percent gain scenario is likely and 17% to 18% is possible if everything goes right,” Colas concludes.

It’s also worth considering that valuations are one of the worst ways to pick stocks, given the market tends to reward what’s working.

In other words, investors have permission to treat themselves.

Write to Teresa Rivas at teresa.rivas@barrons.com