Why Price ÷ Earnings ≠ Insight

Thoughts on the Market

We’re clearly entering the peak summer lull, where markets don’t seem too fazed by much — especially not the bad stuff.

For now, the spotlight remains firmly on earnings, with results continuing to come in strong.

So far, more than a third of S&P 500 companies have reported, and 84% have beaten expectations on the bottom line, with an aggregate earnings surprise of 6.9%. With that, Q2 earnings growth is currently tracking at 8.3% year-over-year, which would bring EPS to $65.5 for the quarter, if that pace holds.

In short, we could be in for another round of upward revisions, just like in Q1 — when analysts got a bit too bearish and had to play catch-up once the real results rolled in.

That said, strong earnings sentiment should keep fueling this rally, as solid EPS growth usually calls for an above-average equity allocation. But right now, stock positioning is still pretty neutral.

Of course, one of the main pushbacks we keep hearing is that the S&P 500 is trading back above 22x forward earnings. That was also the most common response to our take last week that prices aren’t all that stretched in the grand scheme of things.

We don’t usually put much weight on valuations anyway. They’ve never been great for timing. They don’t tell you when a market tops or bottoms. And historically, there’s not much of a relationship between valuation and short-term performance.

Even the act of comparing today’s multiples to their 10-year averages is, in our view, conceptually flawed. It implicitly assumes the index’s earnings structure and risk profile haven’t changed over the years — but they clearly have, especially with how much the sector mix in the S&P has shifted over time.

For us, the one thing that best captures most of these changing effects is profit margins. It’s obviously not perfect in that regard, but it’s a pretty intuitive way to explain why large-cap valuations have drifted higher in recent years.

So, with the S&P’s forward P/E now hitting a 4-year high at 22.6x, it’s worth taking a closer look at valuation and profitability — especially since the “stocks are expensive” narrative is likely to make a comeback.

Let’s start with the chart below: the top panel shows the S&P’s forward P/E since 2000, and the bottom panel shows forward profit margins.

If you’re comparing today’s 22.6x multiple to the 10-year average, you’re also comparing it to a period when margins averaged about 12.25%. Right now, they’re closer to 14%.

That context matters.

Next, we decided to plot historical P/E ratios against profit margins, and what quickly stands out is that there’s a rising relationship between the two — meaning higher margins usually come with higher multiples.

The shaded area around the trendline represents ±1 standard deviation.

That said, the low R-squared value of 0.251 tells us that this relationship isn’t a particularly strong fit. So, to gain better insight, we color-coded the data in 5-year intervals.

The most eye-catching period is 2000 to 2004, which mainly captures the long de-rating phase after the Dotcom bubble burst in early 2000.

This period significantly skews the data because irrational behavior pushed the S&P 500’s earnings multiples way up, even though profit margins weren’t supporting it.

By removing that period, we’re still looking at over 20 years of daily data, and the fit of the relationship improves noticeably to 0.601. The shaded area — which shows ±1 standard deviation from the trendline — is also much tighter.

This tells us that current multiples of 22.6x earnings, with margins near 14%, are just about 1 standard deviation above the trend. So, in this context, the market isn’t exactly shouting “overvalued” when you look at it this way.

Another interesting observation is that the S&P 500 rarely falls below 2 standard deviations from the trend.

If you’re curious about that “cloud” way above the shaded area — where readings went past 3 standard deviations — that’s from the 2020–2024 period, in case that surprises you.

Our next chart zooms in on those years and connects the dots to show how the S&P 500 moved during that time. Turns out, most of that crazy “cloud” happened in just a 12-month window during lockdown, when irrational exuberance was the name of the game.

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Now that we’ve seen that higher profitability basically means — or even demands — a higher valuation premium, we want to adjust the data accordingly.

Our next chart shows the unadjusted forward P/E ratio since 2005 in the top panel, while the bottom panel shows the data adjusted for profitability.