Does Valuation Still Matter?

I recently returned from a trip to the UAE, where I met a number of financial advisors with a range of retail and institutional clients. Apart from the very topical US election results and the implications of a Trump Presidency, the most frequently asked questions focused on the outlook for the US equity market, which inevitably evolved into a debate about valuation.

In general, although Warren Buffet’s record cash holdings were generally (and correctly) interpreted as a reflection of his caution on the market, the consensus was that the US market, or more specifically, US technology stocks and most prominently, the Magnificent 7, (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla) were now in some way detached from valuation constraints and likely to continue to outperform as they have done so spectacularly for so long.  

Sometimes in this game charts can be very informative and save pages of text, so with that in mind I thought the following charts would make for interesting reading. In summary, they show the extent of the outperformance of the US equity market versus the rest of the world, especially over the last five years, alongside the remarkable performance within the US market of the Magnificent 7.

The Magnificent 7 now accounts for nearly one-third of the S&P 500, having been 13.7% just ten years ago. As remarkable is the fact that the S&P 500 now accounts for over 60% of the global equity index, having been just over 20% ten years ago. By way of comparison, according to the IMF, the US economy accounts for approximately 26% of global GDP in nominal terms and 16% in PPP (Purchasing Power Parity) terms.

So, the US market has significantly outperformed other developed economy markets for many years, and leading technology stocks in that index have led to that outperformance. But the most important question posed by my audience in the UAE last week was, "Is this sustainable?" A majority of the audience, by the way, thought that it was and furthermore thought that it would be dangerous, if not reckless, to bet against it, which probably reflects a more widely held consensus view.

Before giving you my view, I need to break this question into three parts:

1. What is the US market's current valuation, and what does this look like in a historical and international context?
2. What is the relevance of valuation as a predictive tool? Is valuation at all correlated with future returns?
3. If a market or stock is overvalued, does that mean its price will fall?

To help answer these questions I am going to use a number of charts. I hope you find them useful.

US market valuation

First to the current valuation of the S&P 500 and importantly where that valuation sits in an historical and international context.

As you can see from this chart, the current price-earnings ratio of the US market, based on 2025 earnings, is very high in the context of the last 37 years and by comparison with other developed economy markets. The UK and Italy, by the same measure, look extremely cheap.

A market’s PE is one way to look at valuation, but there are other tools professional investors use. One of these is price to book, which compares the market value of a company’s shares with the book value of its assets (as shown on its balance sheet) minus the value of its liabilities. Without getting too complicated, in summary, a high price-to-book valuation (where a company’s market value significantly exceeds its book value) would normally imply that a business or indeed a market was generating high returns on equity. The chart below plots the price-to-book ratio of the US market from 1980 through 2024 and also includes a ten-year rolling average.

Finally, here's one more chart showing the S&P 500 Shiller CAPE ratio (Cyclically Adjusted Price Earnings ratio) below. This metric was developed by the US economist Robert Shiller and is calculated by dividing the current price of the S&P 500 by the ten-year moving average of its inflation-adjusted earnings.

These charts tell you what you probably already know: the US market is highly valued compared to its history and to other developed markets.

But what does this mean?

If the US market is richly valued, is that predictive of anything?

To answer that question, I need to show you how valuation correlates with future return. The first chart below maps the 10-year annualised real stock return against the CAPE ratio in the US market from 1980 through to 2014. What this clearly shows is that when investors buy the market at high valuations, above 20-25 times earnings, the subsequent 10-year real returns are at best mid to low single digit and at worst significantly negative. Conversely, the subsequent ten-year real returns are very attractive for investors who buy the market below 20 times earnings.

This next chart shows something very similar for the UK and US equity markets. It maps the 10-year average real return per annum against the market's starting PE (not the CAPE). Again, high valuations correlate with low subsequent returns, and low valuations with high returns. It is, as I have said, intuitive but equally a historical fact.

So, the answer to the question, “Does this tell you anything?”: yes, it does.

What these two charts show is intuitive. If, when you invest, you buy an asset at an elevated valuation, history, and indeed common sense, tells you that you should expect lower returns in the future than if you had not overpaid.

Does this mean that the S&P 500 is about to fall?

Emphatically, no, it doesn’t.

Stock market history tells us that valuations can remain elevated for a long time. Indeed, overvalued markets can become even more overvalued.

But what this data does tell me is that when investing in an overvalued company or market, investors need to understand that their investment decision is not supported by an asset’s intrinsic value. It is supported only by the greater fool theory, which proposes that you can profit from investing in overvalued assets as long as there is a greater fool than yourself to buy the investment at a higher price. You are also unequivocally betting against the long-run history of investment.

Summary

This is not an easy subject for investors to get their heads around.

The fear of missing out in a market that has performed as well and for as long as the US market has done is palpable. I also have to confess that my own valuation discipline as an investor would have driven me out of the Mag 7 a long time ago.

It’s also important to remember that markets don’t have to correct overvaluation as they did in 2000. Markets and stocks can correct for these excesses by just underperforming for a long time, as the Nifty 50 did after the boom in the 1960s and 70s. In summary, I think the US market is pregnant with many great investment opportunities, but I would avoid stocks, like the Mag 7, that are priced (in my view) for perfection.

This subject is complex, and unfortunately, there are no easy answers. Predicting the future is not straightforward and relies much more on art and judgment than science.