MARK SEYMOUR: Valuations on thin ice: lessons from a century of markets

The S&P 500 is priced for perfection. At a price-to-earnings (PE) ratio of 29.5, the index sits far above its century-long average of 17.8. Such stretches rarely last, and reversals can be abrupt. Corporate earnings have grown steadily for 90 years, yet high valuations, soaring debt and inequality make today’s backdrop look uncomfortably familiar. 

The accompanying chart compares the S&P 500 index to its fair value (shaded area), which is defined by a PE range of 10.7 to 21.8 times. The dotted line depicts a constant earnings growth of 6.5% since January 1932. 

From the 1930s to the present corporate earnings have grown at an average annual rate of 6.5% (red dotted line), with stock market prices generally aligning closely to this path. This long-term relationship highlights how valuations tend to revert to their mean over time, despite short-term deviations. 

However, there have been significant exceptions, such as the Great Depression after the 1929 stock market crash, when earnings dropped 75% over three years and took 15 years to recover fully. Since the 1930s nominal earnings have generally trended upward, but this growth has been interrupted by periods of weakness during economic recessions. These downturns are often triggered by external shocks, policy choices or structural shifts that reduce consumer demand, increase costs and compress profit margins. Key examples include:  

• The late-1940s post-World War 2 recession, caused by declining consumer spending and monetary tightening.  
• The 1970s oil crisis and stagflation, driven by skyrocketing energy prices and persistent inflation.  
• The early-1980s Volcker recession, stemming from sharp interest rate increases to curb inflation.  
• The 2008 global financial crisis, sparked by the housing bubble collapse and widespread bank failures.  
• The 2020 Covid-19 pandemic recession, resulting from global lockdowns and supply chain disruptions. 

The consistent 6.5% annual earnings growth observed historically stems from several core drivers: 

• Inflation, averaging about 3.5%, which enables companies to raise prices and revenues in nominal terms.  
• Workforce expansion through population growth and increased labour force participation, boosting aggregate demand and output.  
• Productivity improvements driven by technological innovations.  
• Firm-level tactics, such as operational enhancements, financial engineering and smart capital deployment (share repurchases or targeted investments, for example).

Competition 

Building on these growth factors, competition acts as a fundamental balancing force in the corporate world. It keeps aggregate earnings growth anchored to the economy’s nominal expansion, which combines inflation with real GDP elements like workforce increases and technology-fuelled productivity. In the absence of competition, companies could sustain extraordinary profits indefinitely.

Yet pressure from incumbents and newcomers erodes these excess returns, spreading economic benefits more broadly and maintaining earnings growth on a stable, long-term path, as the graph illustrates. 

Applying the Gordon growth model and assuming corporate earnings growth is limited to 6%-7% due to competition’s enduring role, one perspective holds that the S&P 500’s current PE ratio of 29.5 times already incorporates positive elements such as elevated returns on equity (ROEs), increased reinvestment rates and reduced hurdle rates.  

A counterview suggests that powerful barriers are shielding major tech firms — which account for over 30% of the index’s weight — from typical competitive pressures. These include widening economic moats via acquisitions that eliminate rivals, user lock-in through network effects and platform control, and dominance in AI backed by vast proprietary data and computing power. 

Reality check 

A 2021 literature review by Jack Salmon analysing 40 empirical studies from 2010 to 2020 provides strong evidence that higher public debt levels are linked to reduced economic growth. This relationship often plays out through “crowding out” effects, where government borrowing vies with private sector capital needs, driving up interest rates and stifling investment, innovation and productivity.  

The US gross federal debt stands at 119% of GDP — its highest level — and is projected to keep rising, undermining the nation’s capacity for growth and debt reduction. Unlike the post-World War 2 era, when the US escaped high debt through demographic advantages and intentional interest rate suppression, today’s challenges include an ageing population, escalating healthcare expenses, ongoing primary deficits and greater dependence on foreign investors for debt financing.  

Moreover, headwinds to consumer demand reminiscent of those before the Great Depression are re-emerging, such as heightened inequality and a growing disconnect between wages and productivity gains. Boosted by stimulus measures and market surges, the top 1% now controls over 30% of household wealth — a concentration last seen before the depression. Similarly, today’s tech boom (echoing the 1920s electrification surge) is propelling productivity without corresponding wage increases, which is weakening consumer demand.  

In light of these insights investors in the S&P 500 should exercise caution. With valuations stretched well beyond historical norms (average PE of 17.8 times since 1932), persistent structural risks like soaring debt, inequality and competitive distortions could precipitate sharp corrections or prolonged underperformance, mirroring past bubbles that ended in severe downturns. Diversification, vigilant monitoring of economic indicators and a focus on fundamentals are essential to navigate this precarious environment. 

Markets can defy gravity for years but not forever. The S&P 500’s lofty level assumes today’s exceptional conditions will persist. History warns they won’t. Diversify, stay vigilant and remember: in markets, reversion to the mean is inevitable. 

Seymour is portfolio manager at Northstar Asset Management.