Despite tariff uncertainty, upheaval in the Middle East, and lingering elevated interest rates, the S&P 500 has surged to new highs in 2025. With that strength comes a familiar debate: are we overvalued? That is to say, is the market too high and likely to go down soon? While there is no single metric to determine whether things are overvalued, one of the simplest and most popular ways to measure valuation is the price-to-earnings ratio (P/E ratio¹), which compares a company’s stock price to its profits. The idea is that stock prices should go up more or less in sync with profits. A high P/E ratio¹ is an indicator of a lot of optimism for the future and can be interpreted as an overvalued market.
Historically, the average P/E ratio¹ of the S&P 500 is right around 16. Today, we are seeing valuations of around 29-30², which is quite a bit higher than historical norms. I will point out that some people believe modern-day P/E ratios should be higher and can’t be compared apples to apples to those of the past. The thought is that compared to the early 1900s, today’s companies have higher profit margins³, broader investor access via global and retirement funds, and less cyclical risk (think about today’s massive companies versus the railroads, steel companies, and auto manufacturers of the past). In fact, the average P/E since 1975 is just under 20, which puts the current number in a slightly different lens.
While I do think there is validity to the idea that P/E ratios can be sustainably higher than in the past, it’s difficult to say how much higher valuations should be. Aside from an elevated P/E ratio, I am starting to see anecdotes that are reminiscent of market bubbles of the past. We are seeing retail investors dabbling in “meme⁴” stocks similar to in 2021 and trading extremely speculative zero-day options (which allow investors to make highly leveraged bets on intraday market moves). Just last month, Meta gave a 24-year-old artificial intelligence (AI) prodigy a $250 million contact, including around $100 million in the first year alone. In the back of my mind, I can’t help but think that the belief that valuations could be permanently higher⁴ due to AI and lower rates reeks of a “this time is different” approach that has caused so many people to get burned in the past.
From my vantage point, a lot of the gains we have seen over the past few years are due to optimism around AI. In fact, some analysts project that Microsoft, Alphabet (Google), Amazon, and Meta will combine for around $400 billion in AI-related spending in 2025. Despite the uncertainty, there is a genuine possibility that AI will change life as we know it and lead to productivity gains, not only for Big Technology companies but for all kinds of companies. If that is the case, we might look back in a few years and realize that valuations were actually low⁵ given the opportunity.
One more thing that’s important to remember is that even if the market is overvalued, that is not a guarantee we will get a downturn anytime soon. As an example, during the “dot-com mania” of the late 1990s, the P/E ratio¹ of the S&P 500 got to 44. In the technology-focused NASDAQ⁶, the ratio is estimated to have been about 175, but it’s hard to pinpoint because so many companies had no earnings at all! All this is to say: there is no way to predict how large a bubble can grow.
Given everything I have written, what should you do? Does it make sense to take your gains and get out of the market? Should you go all in on AI and hope for the best? It’s hard to say what the best approach is. It’s entirely possible that we have a few more years of great gains, especially if companies can demonstrably improve their profit margins using AI. With so much uncertainty at the moment, it’s important to focus on fundamentals.
Overall, we are in a difficult investment environment. The potential for AI to impact businesses and their stocks seems unprecedented, but there are still minefields out there to be wary of.
If you are a client of mine, we will review your portfolio during our fall meetings and make sure you are on track with your long-term plan. If you’re not a client, consider this a friendly reminder to check up on your investments. The most important thing is making sure your portfolio matches your comfort level and long-term plan. Even small adjustments can make a big difference in how confidently you move forward. If you’d ever like a second set of eyes on your plan, I’m always happy to help.
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References:
¹ S&P 500 P/E Ratio Data & History – https://www.multpl.com/s-p-500-pe-ratio
² Historical Average P/E Ratios – https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html
³ Aswath Damodaran – P/E Trends – https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html
⁴ Market Bubble Signals & Meme Stocks – https://www.wsj.com/markets/stocks/meme-stocks-return
⁵ Big Tech AI Spending Projections – https://www.cnbc.com/2024/06/03/microsoft-google-amazon-meta-to-spend-on-ai.html
⁶ NASDAQ Dot-Com Bubble Valuations – https://www.investopedia.com/terms/d/dotcom-bubble.asp