Have U.S. stocks become too expensive?

With equity valuations close to their historical highs, many investors are understandably nervous that U.S. stocks have become too expensive given a relatively modest outlook for economic growth. But the U.S. market is heavily tilted toward the ongoing buildout in artificial intelligence, or AI, which happens to be the part of the U.S. economy where growth is booming. This has led to strong and improving market fundamentals.

U.S. stock valuations have been steadily climbing since early May. As of August 25th, the forward price to earnings, or P/E, multiple for the S&P 500 Index stood at 22.24, just below the post-COVID peak set in August 2020 and the technology bubble peak from December 1999.

Such expensive valuations are particularly surprising now because the U.S. economic outlook appears relatively modest. According to Bloomberg’s most recent survey of economists, U.S. gross domestic product, or GDP, is expected to grow below the long-term historical average both this year and through 2027.

In addition to concerns about a sharp rise in tariffs, the interest-rate-sensitive sectors of the U.S. economy have shown significant weakness since the Federal Reserve hiked rates in 2022.

U.S. manufacturing, for example, has been muddling along for more than 2½ years. For 31 of the past 33 months, the Institute for Supply Management’s index of manufacturing conditions has been below 50, a level that indicates economic contraction rather than expansion. Such an extended period of U.S. manufacturing weakness is unheard of outside of a recession.

The housing sector also has been notably weak. Existing home sales and new housing permits both fell sharply in 2022 in reaction to a sharp rise in mortgage rates triggered by the Fed hiking cycle. There has been almost no rebound since then, as mortgage rates have remained stubbornly high.

There is one area where U.S. economic activity has boomed: artificial intelligence. Capital expenditures in this area have been driven by four mega-cap tech companies widely known as the “hyperscalers.” Wall Street analysts currently expect these companies to invest almost $430 billion next year into their AI capabilities.

So far, the hyperscalers have been able to fund AI capex spending from their own cash flows rather than taking on debt. This means that elevated interest rates have not been an obstacle. It also means that companies involved in the AI buildout—such as semiconductor producers and cloud computing, data center, and networking equipment providers—have enjoyed exceptional earnings growth.

The booming AI sector happens to carry a much heavier weight in the U.S. stock market than the interest-rate-sensitive sectors. This means U.S. stock market fundamentals can be strong despite modest overall economic growth.

And they have been strong. Forward earnings estimates for the companies in the S&P 500 Index have risen steadily since the end of May. As of late August, S&P 500 earnings were projected to grow more than 12% over the coming 12 months. Actual results have been strong as well. S&P 500 earnings grew 10.25% over the 12 months ending August 25th, and growth has been trending higher since June.

Meanwhile, S&P 500 profitability measures are also high and rising. Operating margins have topped 15%, continuing the long-term strengthening trend seen over the past 25 years. Return on equity also has continued to move higher, reaching nearly 21%. These fundamental metrics underpin the sustainability of the upwards trend in earnings.

U.S. equity valuations appear expensive, but are supported by strong and improving fundamentals. In our view, this means stock market returns can remain strong despite elevated valuations—as long as the fundamentals hold up. 

But, if those fundamentals were to weaken, the potential for downside risk would be more significant than normal.

As a result, the T. Rowe Price Asset Allocation Committee currently maintains a neutral weight in U.S. stocks versus bonds despite elevated valuations. However, we will continue to keep a close eye on the underlying fundamentals.