As we look towards 2025, the relatively high valuation of many U.S. stocks may add to investor risk. On most valuation metrics, the U.S. stock market appears expensive compared to history, often at double historical norms. That may imply lower returns in future years.
It’s important to remember this after a generally strong bull market since at least 2022 and U.S. markets outperforming foreign stocks fairly consistently since the 2008 financial crisis, investors may be becoming accustomed to strong U.S. stock performance. Yet, market corrections are very much part of investing history too.
Elevated Valuation Metrics
Famed investor Warren Buffett likes to look at the ratio of stock market valuation to U.S. GDP as a rough valuation gauge. It’s at currently double its long-term average. But whether you look at price to current earnings or price to sales, most metrics tell a similar story, the U.S. market is richly valued today compared to its own history. We can roughly say that most valuation metrics are at approximately double their historic levels, much like Buffett’s preferred indicator.
The Prevalence Of U.S. Tech
Part of this may be due to the concentration of tech stocks within the U.S. market. These companies are argued to be asset light, robust and well-managed businesses and hence deserve a premium to less well-positioned and less agile companies of the past.
However, China has cutting edge A.I. models too. It’s also not clear how much of the strength of these tech businesses is already reflected in their high profits. As such paying a large valuation premium for those profits could be, in a sense, double counting.
The Importance Of Earnings Growth
In the long-term stock market returns track earnings growth. That’s why historically simply staying invested in U.S. stocks and not fretting about news and valuations has been a reasonable strategy.
However, in the short term swings in valuation can dominate what has historically been fairly steady increases in overall earnings. If currently rich valuations were to fall back to historically average levels then that may create a headwind for stocks that would be hard to overcome, at least for a few years.
Valuation Comparison To Bonds
Furthermore, in recent history it was argued that the stock market should be at a relatively high valuation because bonds too were trading a relatively high prices. A bond’s valuation is essentially the inverse of its yield. So in 2020 when the 10 year Treasury bond yielded under 1%, it was perhaps natural to expect stock valuations to be at similar levels. That’s because stocks and bonds are, on some level, substitute assets for investors. However, now the 10 year yield stands at over 4%, that’s much closer to a historically normal level despite the Fed cutting rates, yet stock valuations have, if anything, risen while bond valuations have declined.
Factors To Consider
Generally, trying to time or predict the moves of the stock market is an almost impossible task. Indeed, the short-term unpredictability of stocks may be a major factor enabling their long-term outperformance.
Nonetheless, U.S. stock valuations stand at high levels compared to history. This comes at a time when other international stock markets are generally much closer or even below historically average valuation levels and when bond markets too offer high yields compared to recent history. Perhaps U.S. stocks will continue their strong run in 2025, but investors should be conscious of the risks if they don’t. At a time when international markets and fixed income currently appear to offer much more moderate valuation levels. Some diversification may be prudent.
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